credit spreads are widening is the below a positive or negative impact on the portfolio:
Trade: Buy a 5 year callable corporate/Sell a 5 year noncallable corporate of the same issuer
2015 AM Q3 B
credit spreads are narrowing Should you implement the below trade:
buy a callable corporate bond and sell a noncallable corporate bond same maturity and credit quality.
BOTH answers say no because of the negative convexity effect. Which I get, but what is the rule of thumb here? Spreads narrowed in one and widened in the other??? help.
For 2015 Q3 B, the trade is going to have a negative impact on portfolio value because when spreads are going to narrow / interest rates fall the risk of the callable bond being called back to the issuer is higher, so the callable bond will underperform a similar non-callable bond. (This relates to reinvestment risk, because if it gets called and interest rates fall you just received the bond back since it was called and now you have to reinvest in a lower interest rate environment)
for the 2008 Question, was the answer that the trade would be negative? I’m not to sure about that one but I’d say that the 2008 question would be yes, not not sure.
Yea just looked at it, credit spreads will widen but you didnt consider the interest rates are going to fall, since callable bonds have negative convexity their appreciation from the interest rate decline will not be as much as the price appreciation of the non-callable.
In '15 it explicitly says that she expects yields to experience a downward shift, which is a better environment for non-callables, as callable bonds can exhibit negative convexity with the increasing likelihood of getting called.
Basically, lower rates means higher call risk for the callable, and the price of the non-callable will benefit from the lowering rates and narrowing spreads.
is a downward parallel shift in the yield curve (2015) the same as a decline in interest rates (2008) if they are the same then the logic still doesnt make sense to me…
ignoring the shift in the yiled curve in 2015 and the decline in rates 2008… the two questions state different directions of credit spreads. this is what im trying to get. i know all that about decline in rates means increase in bond prices and not as much for a callable because of convexity effect. im not asking about that.
The only thing I can think of is that one Q relates to interest rates and the other to credit quality. The 2015 Q, I agree with agulani. 2008, it’s the same issuer’s bonds, so maybe that’s the trick? Although I’m still not sure why you wouldn’t want to swap into the callable bond, even if it was credit quality related.
ajb1, you wouldn’t want to swap into a callable bond when interest rates are falling because the convexity of callables means less price apprciation for the callable Vs non-callable.
I have not had time to read the 2008 question but based on the comments a downward shift in interest rates is bad for callables. This has been confirmed several times!
With regards to credit spreads, the callable and non-callable bond is issued by the same issuer so the credit spread affect will be the same for both callables and non-callables. However, note that the value of a callable bond = -Call option + Bond Value so when rates increase the callable bond falls less than a non-callable bond. But based on lower interest rates the value of the trade is negative.