Duration Times Spread (DTS): An Overview

Financial markets have a variety of metrics and indicators that aid in analyzing, understanding, and predicting market trends.

One such tool is Duration Times Spread (DTS), a market standard method used to measure the credit volatility of a corporate bond.

Key Takeaways – Duration Times Spread (DTS)

• Duration Times Spread (DTS) is a useful metric for measuring the credit volatility of a corporate bond.
• It combines spread-duration and credit spread to quantify the bond’s sensitivity to changes in credit spreads and the additional yield it offers compared to risk-free bonds.
• DTS calculation is straightforward, obtained by multiplying the spread-duration (bond’s price sensitivity to credit spread changes) by the credit spread (yield difference between the bond and a benchmark security).
• A higher DTS implies greater volatility and risk.
• While DTS is a handy tool for credit analysis and portfolio management, it has limitations. It assumes parallel shifts in the yield curve, doesn’t account for changes in credit spread over time, and ignores other risk factors.
• Therefore, DTS should be used as part of a comprehensive risk management strategy and not in isolation for investment/trading decisions.

Understanding DTS: Spread-Duration and Credit Spread

To comprehend the DTS calculation, it is essential to understand its two components:

• spread-durations, and
• credit spreads

Spread-duration, also known as credit duration, measures the sensitivity of a bond’s price to changes in credit spread.

It effectively assesses how much a bond’s price will change if the credit spread changes by a certain percentage.

On the other hand, credit spread is the difference in yield between a corporate bond and a no-credit-risk government bond with similar maturity.

It essentially quantifies the additional yield that an investor demands for taking on the risk associated with the corporate bond.

The DTS Formula & Calculation

The DTS calculation is a straightforward multiplication of spread-duration and credit spread.

It is a simplistic yet robust method for quantifying the risk associated with changes in the credit spread of a corporate bond.

Here is the formula for calculating Duration Times Spread:

DTS = Duration * Spread

Where:

• Duration = The length of time of the fixed income security (typically measured in years)
• Spread = The yield spread of the security over a benchmark rate like US Treasuries. This measures the extra yield or risk premium the security offers over a “risk-free” government bond.

The spread is usually quoted in basis points. 1 basis point = 0.01%

Example Calculation

So for example:

A 5-year corporate bond has a spread of 150 basis points (1.5%) over comparable 5-year US Treasuries.

Say the US 5-year Treasury note yields 2.5%.

So the corporate bond yield = 2.5% + 1.5% = 4%

• Duration = 5 years
• Spread = 150 basis points (converted to percentage and decimal: 1.5% / 0.015)
• DTS = Duration x Spread = 5 x 0.015 = 0.075

So the DTS for this bond is 0.075.

The DTS calculation gives you a measure of the additional yield you obtain by holding this bond versus a Treasury bond until maturity, assuming no default or credit losses.

The higher the DTS, the more excess yield you are obtaining for the extra credit risk of the bond.

Why is DTS Important?

DTS offers a composite measure of both the bond’s price sensitivity to changes in credit spreads and the inherent risk in the corporate bond relative to risk-free bonds.

It’s a tool for credit analysts, portfolio managers, and risk managers in their day-to-day decision-making process.

Limitations of DTS

Here are some key limitations of the Duration Times Spread (DTS) calculation:

• DTS assumes parallel shifts in the yield curve, when in reality yields may shift in a non-parallel fashion. So it has limited accuracy when yield curve changes are more complex.
• DTS doesn’t account for changes in credit spread over time. It assumes the credit spread remains constant over the bond’s life, which may not be the case.
• DTS relies on duration, which has some limitations itself in measuring interest rate risk, especially for bonds with embedded options.
• DTS looks at spread in isolation when comparing bonds. It ignores differences in liquidity, callability, and other risk factors across bonds.
• DTS is useful for a quick and easy relative value comparison across bonds. But it provides an incomplete picture of the risks and returns of investing in a particular bond.
• DTS works better for comparing bonds with similar characteristics (sector, maturity, etc). Comparing across diverse bonds, the metric becomes less meaningful.
• DTS is more relevant for institutional investors trading on a relative value basis. It has less utility for buy-and-hold investors concerned about total return.
• DTS can be used to compare bonds denominated in the same currency. It is not applicable across bonds in different currencies.

So, DTS has simplicity on its side as a handy metric.

But its limitations mean it should not be used in isolation to make investment/trading decisions.

More rigorous analysis of a bond’s overall risk-return profile is required for prudent bond trading.

Fixed Income: Excess Returns on Credit Risky Bonds

FAQs – Duration Times Spread

What is Duration Times Spread (DTS)?

Duration Times Spread (DTS) is a common metric used in the financial markets to measure the credit volatility of a corporate bond.

Credit volatility is a bond’s sensitivity to changes in credit spreads, which are the differences in yield between two bonds of similar maturity but different credit quality.

The DTS is calculated by multiplying two bond characteristics: the spread duration and the credit spread.

How is Duration Times Spread (DTS) calculated?

DTS is calculated by multiplying a bond’s spread duration with its credit spread.

The spread duration measures the bond’s price sensitivity to changes in the credit spread, while the credit spread itself represents the yield difference between the bond and a benchmark security (usually a risk-free government bond).

By multiplying these two factors together, you get a measure of how much the bond’s price would change for a given change in credit spreads.

How does Duration Times Spread (DTS) affect bond pricing?

DTS affects bond pricing by determining the sensitivity of a bond’s price to changes in the credit spread.

A higher DTS implies greater volatility, and therefore more risk.

This could result in a lower bond price as investors demand higher yields to compensate for this increased risk.

Conversely, a lower DTS suggests less volatility and might lead to a higher bond price since investors require less compensation for risk.

How is Duration Times Spread (DTS) used in bond portfolio management?

In bond portfolio management, DTS is used to assess the potential volatility of different bonds due to changes in credit spreads.

It helps managers to diversify their portfolio and manage risk by identifying bonds with differing DTS values.

For example, if a portfolio is overly exposed to high DTS bonds, managers might balance the risk by investing in bonds with lower DTS values.

How does Duration Times Spread (DTS) differ from other bond volatility measures?

Unlike other bond volatility measures that focus solely on interest rate risk, such as Macaulay or Modified Duration, DTS specifically measures the bond’s sensitivity to changes in credit spreads.

This is particularly relevant for corporate bonds, where credit risk (the risk of the issuer defaulting) can be a significant factor in pricing and risk assessment.

Can Duration Times Spread (DTS) be used to compare bonds from different issuers?

Yes, DTS can be used to compare the credit volatility of bonds from different issuers.

It gives investors and portfolio managers a consistent metric to assess the potential impact of changes in credit spreads on bond prices across a range of bonds.

This allows for more accurate comparison and portfolio diversification.

How do changes in the market affect Duration Times Spread (DTS)?

Changes in market conditions can significantly affect DTS.

If market perceptions of credit risk increase, credit spreads widen, which in turn could increase DTS values, indicating higher potential volatility.

Conversely, improving credit conditions, reflected in narrowing credit spreads, could reduce DTS values, suggesting lower potential volatility.

Is Duration Times Spread (DTS) relevant for all types of bonds?

DTS is particularly relevant for corporate bonds, where credit risk plays a significant role in pricing and volatility.

However, it can be applied to any type of bond where credit risk and credit spreads are a consideration.

For bonds with negligible credit risk, such as government bonds in stable economies, DTS might be less relevant.

Conclusion

Duration Times Spread, despite its limitations, remains a popular tool in the bond markets.

Its simplicity and robustness in capturing credit volatility have earned it a spot in the toolbox of many financial professionals.

While not flawless, the continued use and reference of DTS in academic studies and by market practitioners underscore its relevance.

As with any financial tool, the key is in understanding its underlying assumptions, appropriate use cases, and potential pitfalls.

With such an understanding, DTS can serve as a valuable component of a comprehensive risk management strategy.