Your Corporate-Bond Duration May Be Longer than You Think
- Common duration measures for callable bonds assume that bonds are called whenever it is economically optimal for the issuer, but don’t account for price uncertainty, refinancing costs or alternative sources of capital.
- When these factors are taken into account, the high-yield index’s duration may extend by as much as three months, while the bond-level duration may extend by one to two years.
- Portfolio and risk managers may want to reconsider the hedging and investment strategies for callable bonds once these effects are accounted for.
Market-standard measures of duration are widely used as a basis for investment decisions in corporate-bond portfolios. These measures can be misleading, however. They assume that the call option embedded in callable bonds behaves like an equity option, where the call decision is formulaic and unambiguous. In reality, bond calls are far more complex. Managers of corporate-bond portfolios may want to consider alternative views of duration that account for these complexities, which may extend index-level duration by as much as three months and bond-level duration by one to two years.
Market-standard duration measures for callable bonds are built on the assumption that the issuer will call as soon as the bond is in-the-money, but that’s only part of the story. In reality, in-the-money bonds may remain outstanding, while out-of-the-money bonds may be called. The two charts below demonstrate this behavior.1
Top panel shows call-eligible bonds in the MSCI USD High Yield Corporate Bond Index that spend some days in-the-money, by month. Bottom panel shows call-eligible bonds and market yield. Source: LSEG and MSCI
Price minus strike of called bonds in MSCI USD High Yield Corporate Bond Index, averaged over the two weeks preceding the call announcement. Year-to-date data through September 2025. Source: LSEG and MSCI
Call behavior deviates from what is implied by the standard model because of additional factors that are not accounted for in the standard model:
- Price uncertainty: Most bonds don’t trade on a given day, and there is a contractual gap (notice period) between when calls are announced and when they are exercised.
- Refinancing costs: These can range from 0.2% to 3.5%.2
- Alternative sources of capital: Issuers may prefer to call bonds and access other sources of capital, including equity, convertible bonds, bank loans and private credit.
In addition to the standard model, MSCI computes analytics using the proprietary MSCI Call Model. Instead of relying on rigid rules, the model allows for suboptimal out-of-the-money calls and delaying in-the-money calls, such that the resulting call probabilities align with observed market data.
Under the standard model, the duration of in-the-money bonds will be close to 0 due to the assumption that in-the-money calls are exercised immediately. In contrast, the MSCI Call Model reflects a significantly higher duration, since it does not assume that the bond will be called immediately. The charts below illustrate this difference.
Array Digital Infrastructure Inc. 6.95 05/15/2060. Source: LSEG and MSCI
Even bonds that are moderately out-of-the-money may show longer durations under the MSCI Call Model. If bond prices had zero volatility, the duration of out-of-the-money bonds would shorten relative to the standard model, because of the possibility of out-of-the-money calls. But since bond prices are volatile, there is some chance that out-of-the-money bonds will become in-the-money. In those in-the-money scenarios, the duration extension is much stronger than the duration contraction in out-of-the-money scenarios, so overall the duration is generally longer in the MSCI Call Model. The charts below illustrate this behavior.
Average yearly effective durations of American call-eligible bonds in the MSCI USD High Yield Corporate Bond Index, split by price over strike.
Even at the index level, during times when there are a large number of in-the-money call-eligible bonds, the MSCI Call Model can show durations that are up to three months longer than the standard model. The exhibit below shows this effect.
Monthly average effective duration of the MSCI USD High Yield Corporate Bond Index.
Bond markets remain highly reliant on market-standard analytics, which provide the benefit of broad consensus on valuations and the effectiveness of hedging strategies. For callable bonds, however, these standards may understate duration. Portfolio managers may benefit from considering an alternative perspective based on a more complete view of empirical call behavior.
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1 The significant dip in the fraction of call-eligible in-the-money bonds during 2021 and throughout 2022–2023 was the result of interacting factors. First, the wave of refinancing in late 2020 and 2021 reduced the share of call-eligible bonds, since newly issued bonds typically come with a few years of call protection. Second, the high corporate yields throughout 2023 meant that bonds were less likely to be in-the-money. This effect has been gradually offset as more newly issued bonds have entered their call-eligible period, leading to a significant increase in the fraction of call-eligible bonds.
2 Dongcheol Kim, Darius Palia, and Anthony Saunders, “The Long-Run Behavior of Debt and Equity Underwriting Spreads,” Salomon Center Working Paper, NYU Stern, January 2003.
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