True or False: Spread Risk

Spread Risk is more of a concern for IG bonds (as opposed to HY).

false. spreads are more of a risk for HY than IG. IG is more sensitive to interest rates.

I think the statement is true. For a HY bond, you care more about credit risk because you’re worried that the issuer won’t be able to make payments and that they will default. For an IG bond, you care about interest rate risk and credit spread risk (the risk that their credit spreads will widen). For securities with large credit spreads, they are less sensitive to interest rate risk because they are HY.

Someone please correct me if I am wrong. I just re-read this chapter this morning and thought I understood this concept.

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spreads = credit risk

as credit risk increases spread increases

That’s what I thought according to Kaplan, but a question in the CFAI Fixed Income TT’s (in the Mt Pleasant Case) says spread risk is more important for IG…mentioning credit spread volatility.

credit risk and spread risk are not the same thing. Read the first bullet under the summary for Reading 24.

credit risk relates to a counterparty not fullfilling their obligations. It can be one sided to the side with a gain or two sided if both are required to make payments, I know.

Credit risk in bonds is reflected through the spreads to compensate investors for living on the edge. HY by definition are riskier and have higher spreads to compensate. Also more illiquid blah blah. They are more sensitive to changes in spreads than IG, and IG is more sensitive to changes in interest rates.

Fallen angels is a risk for investment grades, i.e. when they are downgraded to non-investment grade. Yes, this is a large risk, however HY bonds are, in general, more sensitive to changes in spreads than they are changes in rates. IG more sensitive to changes in real rates.

Am i allowed to quote verbatim from a CFAI example?

Question basically says the following statement is false:

Spread duration (which I’m assuming is spread risk?) is more useful for HY than for IG

Spread duration measures the change in the bonds value based on a change in spread.

%∆P = -DurationSpread*∆Spread.

Pred…I hear you, but the statement I posted is FALSE - i.e. spread duration is more useful for IG (according to CFAI TT)

What’s their explanation of why it’s false just that it’s more useful for IG?

Typically spread duration and modified duration will be the same or close. The big exception is for floating rate bonds who have significantly higher spread duration than modified duration.

SPREAD RISK and SPREAD DURATION (SD) are two different concepts

SD (Reading 24) - IG

Spread Risk is mentioned and explained in Reading 22 (page 89)

I would say spread risk is more of a factor for IG. Spread Risk and Credit Risk are distinct concepts. If the debt is IG, there is less concern that the issuer will be able to repay the obligation. If the spread widens, the MV of the debt decreases.

For HY, the spread is almost unimportant, since it is sub-IG. Quoting on a spread basis is akin to comparing apples to oranges, and doesn’t tell the investor much.

I think we need the finance wizard to chime in on this…

Pg 301 in Schweser… “HY investors…much more exposed to spread risk”

Pg 194 in CFAI… “Because credit spread volatility…is more relevant for IG bonds”

Is credit spread volatility not the same as spread risk (spreads widening over benchmark Treasury bond)?

The spread is between IG and HY so how can you measure which one is more sensitive to the other? Can you post the question, because something is off here?

IG is more sensitive to interest rate risk

HY is more sensitive to credit risk

BUMP- this CFAI TT is confusing with what we have been told in Schweser I agree. CFAI question is “spreard duration is a measure of risk that is more useful for HY bonds than IG bonds”- CFA says FALSE.

So what is most important for HY bonds and IG bonds?

For IG- spread duration (according to CFAI) and IR duration?

And for HY- is it the credit and liquidity?

Thanks!

I looked into this last night. In terms of pricing IG is primarily affected by rates and HY by spreads.

As a measurement of spread risk in the portfolio you have a a couple of options. You can multiply the spread duration by the weight to see the contributed spread risk to the portfolio or you can take the market value weight of the bond in the portfolio. For IG you use the former to measure the contributed spread risk into the portfolio. For HY you use the latter and take the market value weighting given that there will be little chance of recovery in the event of a default. Based on this spread duration might be more important for viewing the risk of IG in the portfolio.

This doesn’t affect the main sensitivity of prices of the two sectors however, which remain interest rates primarily in IG with spreads secondary and spreads in HY.

For non-treasury bonds: Spread duration (percent price change for a 100bp change in the spread above the Treasury curve) is the same as the effective duration (percent price change for a 100bp change in the Treasury rates).

So, if you take 2 bonds: 5-year AA-rated 2.5% / 5-year B-rated 7%

The effective duration for the IG bond will be higher than for the HY bond (all else equal)

And therefore, spread duration is more important for IG than for HY. Because IG is more sensitive to changes in IR and spread.

Any thoughts ??

True but risk is not only spread duration but also spread widening. Spread widening is MUCH more pronounced in high yield debt than in investment grade.

Thing is that CFAI meant to draw a distinction between spread and market value risk, with the former being more important for IG, latter for HY. It’s not meant to be an absolute statement that HY has less spread risk.

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