Hi, In the CFA text one of the disadvantage of using Emperical duration : THe volatility of the spreads over Treasuries can distort the price reaction to interest changes. (also Schwser text book 5 page 169). can someone help explain this, or give an example??
So on July 1 a bond is trading at 8% at a spread of 2% and on August 1 it’s trading at 8.2% at a spread of 2.5%. Maybe the change in the ytm in the bond came because of the change in interest rates or maybe it happened because of a change in credit spreads or any number of other reasons. Obviously, you wouldn’t use just two points to calculate empirical duration, but you have to deal with this error term somehow.
Feb 2008 is a great example. the treasury curve rallied (yields dropped) anywhere from 5-40 basis points. treasury bonds had a huge month, returning over 1.5%. you would expect mortgages (which are bonds, obviously) to also have a great bond since treasury yields came down so much. HOWEVER, most mortgages had negative returns for the month. why? because of fear of anything mortgage, spreads to treasuries widened way more than treasury yields rallied. empirical duration would never have expected mortgages to have negative returns as yields drop. doesnt that sound like negative duration?