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erstwhile
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Joined: March 3rd, 2003, 3:18 pm

Rate risk in high yield bonds

September 22nd, 2019, 6:37 pm

It’s well known that bonds trading at very high spreads empirically “lose their rate sensitivity” (compared to the standard model) - they act more equity-like empirically and of course if they are distressed enough start trading near the market view on recovery.  I was thinking that pricing a bond using a CDS-model-type approach would automatically produce much lower rate sensitivity when spreads are high, and would also produce prices tending to the recovery value. But it seems nobody models HY bonds this way.

Why is that? Because the recovery is “too unknown”? If you have a portfolio with bonds and CDS in it and you use two models with very differing assumptions, why would you expect to get the right rate risk?
 
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bearish
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Joined: February 3rd, 2011, 2:19 pm

Re: Rate risk in high yield bonds

September 22nd, 2019, 9:23 pm

I can't speak for the world at large, but over the last decade I have been associated with two organizations that somehow did something along the lines of what you are suggesting. Clearly, recovery rate assumptions are tricky, and if you are into bank loans (aka "syndicated loans" or the very odd terminology "leveraged loans") you get more troubles in this area, although interest rate duration is usually not the primary problem.
 
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erstwhile
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Joined: March 3rd, 2003, 3:18 pm

Re: Rate risk in high yield bonds

September 23rd, 2019, 6:02 am

That is interesting, thanks. I expect implied probability of default and spread duration or OASD might be bigger concerns than rate risk.