Hedging a corporate bond with Treasury futures

Question

You hold a corporate bond and want to protect it from moves in interest rates. There is no clean futures contract on this exact bond, but Treasury futures are deeply liquid. You short Treasury futures against the bond.

Have you removed the bond's price risk? If not, what remains, and how should you size the hedge?

Accepted Answer

Decompose the yield. A corporate bond's yield is the risk-free Treasury yield plus a credit spread: y{	ext{corp}} = y{	ext{tsy}} + s{	ext{credit}}, \qquad \Delta y{	ext{corp}} = \Delta y{	ext{tsy}} + \Delta s{	ext{credit}}. A bond's price move is roughly -D \cdot \Delta y (with D its duration). Shorting Treasury futures cancels the piece driven by \Delta y{	ext{tsy}}, the general level of rates. What survives is credit-spread risk. If Treasury yields hold steady but the issuer's spread widens (a downgrade, weak earnings, a risk-off day), the corporate bond falls and the Treasury hedge …

Hedging a corporate bond with Treasury futures

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