Corporate bonds

A change in the OAS of a callable (or puttable) corporate bond directly affects the
cash flows an investor expects to receive, since the corporate issuer (who is long the
call option) will decide whether or not to call the bond on the basis of its price in the
secondary market. If a security’s OAS narrows sufficiently, its market price will rise above its call price, causing the issuer to exercise the call option. Likewise, the
investor who holds a puttable bond will choose to exercise the put option if secondary
market spreads widen sufficiently to cause the bond’s price to drop below the put
price (typically par).
Since changing the bond’s OAS by X basis points has the same impact on its price
as shifting the underlying Treasury yields by an equal number of basis points, the
spread duration for a fixed rate corporate bond is actually equal to its effective
duration.2 Therefore, either spread duration or effective duration can be used to
estimate the impact of a change in OAS on a corporate bond’s price. The same applies
to a portfolio of corporate bonds, so if a risk management system captures the
effective (option-adjusted) duration of a corporate bond inventory, there is no need
to separately compute the spread duration of these holdings. (Note that Macaulay’s,
a.k.a. ‘Modified’, duration is not an acceptable proxy for the spread risk of corporate
bonds with embedded options, for the same reasons it fails to adequately describe
the interest rate sensitivity of these securities.)