Hedging Duration On A Credit Book

A corporate bond's price moves for two mostly separate reasons: the level of risk-free interest rates changes (duration risk, shared with Treasuries) and the market's assessment of the issuer's creditworthiness changes (spread risk, specific to that issuer or sector). A desk holding a book of corporate bonds can hedge the duration piece cheaply and liquidly with Treasury futures or interest-rate swaps, sized to match the book's dollar duration — but doing only this leaves the credit-spread component completely unhedged, since Treasury instruments carry no issuer-specific credit risk to offset against.

Hedging the credit piece is harder and more expensive: it typically means credit default swaps or index products like CDX, which are less liquid, carry basis risk against the specific bonds held, and cost ongoing premium to carry. Because of this asymmetry, many credit books run duration-hedged but credit-unhedged, meaning their remaining P&L volatility is driven almost entirely by spread moves — a fact worth checking explicitly rather than assuming a "hedged" book has covered both risks.

This split shows up starkly during a flight-to-quality event: Treasury yields fall (helping the duration hedge) at exactly the moment credit spreads widen sharply (hurting the unhedged bonds), so a book that looks well-protected on a normal day can still post a large loss precisely when markets are stressed, simply because the hedge was only ever addressing half of the book's risk.