Duration, Default Risk, and the Term Structure of Interest Rates

Abstract

We examine the interactive effect of default and interest rate risk on duration of defaultable bonds. We show that duration for defaultable bonds can be longer or shorter than default-free bonds depending on the relation between default intensity and interest rates. Empirical evidence indicates that in most cases duration for defaultable bonds is much shorter than for default-free counterparts because of the negative relation between default risk and interest rates. Results suggest that the duration measure must be adjusted for the effects of default risk and stochastic interest rates to achieve an effective bond portfolio immunization.

Keywords: Default risk, bond pricing, duration, term structure