Kaplan R22, p53.
Supply and demand analysis can be used to understand bond price and resulting spread changes, with sometimes surprising results. Increases in the number of new corporate bond issues are sometimes associated with narrower spreads and relatively strong returns
Can someone help to explain above in bold? Does it mean more supply will attract even more demand?
Many thanks.
i think what they are trying to say is that usually in a low interest rate enviornment (narrower spreads), we see companies doing more bond issues and as the companies also are performing well with strong returns they can afford to issue debt in the market at lower spreads to to their overal financial strength
This ones seems counter-intuititive. Typically, you think more supply, lower prices. In this case, the curriculum says that more new-issue supply leads to price/yield affirmation on existing bonds in the market, and results in lower spreads, higher prices.
CFAI material acknowledge that the statement above is counter-intuitive and this is what they say “Contrary to the normal supply-price relationship, relative credit returns often perform best during periods of heavy supply….the premise, ‘supply will hurt spreads,’ which may apply to an individual issuer, does not generally hold up for the entire credit market**. During most years, increases in issuance (most notably during the first quarter of each year) are associated with **** market****-spread contraction and strong relative returns for credit debt. In contrast, sharp supply declines are accompanied frequently by spread expansion and a major fall in both relative and absolute returns for credit securities. For example, this counter-intuitive effect was most noticeable during the August–October 1998 interval when new issuance nearly disappeared in the face of the substantial increase in credit spreads. (This period is referred to as the “Great Spread-Sector Crash.”)”**
A possible explanation is that the new primary valuations validate the prices of outstanding issues which relieves price uncertainty and reduces all spreads and hence enhances the secondary valuations. Another way to think of it is that the increase in supply attracts attention and could be associated with even larger demand. Likewise, according to CFAI, “when primary origination declines sharply, secondary traders lose reinforcement from the primary market and tend to reduce their bids, which will increase the spread”. Another reason could be that “more bonds are issued during expansions, when companies are doing well” which also validates the state of the economy (and ultimately the bond market) and hence the narrowing of spreads.
Thanks all, it’s indeed pretty counter intuitive…
Thanks all - very helpful