Break even Spread analysis

CFA Level III
#1

Hi All,

I suppose that yield advantage of investing in the foreign country can vanish if the yields in domestic markets increase or the foreign yields decline.As per example 20 CFAI currilculum pg 254 Volume 4 .It says spread widening and falling yields in the domestic currency makes foreign bond investment futile. Can someone please explain…

#2

Hey, i think you might have mixed that up! I don’t have the CFAI text in front of me, but i just read up this part last night and here is my take on it:

Spread advantage of holding the foreign bond = Foriegn yield-Domestic yield.

Spread can widen either by increase in foreign yield OR decrease in domestic yield.

Foreign yield goes up --> Foreign bond prices fall --> Advantage of holding foreign bond is lost on a total return basis --> better to hold a domestic bond.

Domestic yield goes down --> Domestic bond prices rises --> Advantage of holding domestic bond as domestic bond prices rise --> better to hold a domestic bond.

Therefore if spread widens, foreign bond advantage is lost.

#3

hitesh,

Very nicely written explanation. Thanks. Can you provide rationale for the formula we use to calculate break even spread please?

Thanks

#4

Note that the investor chooses to chase yield, and therefore invests in the country with the higher yield, in this case France. ALL ELSE EQUAL, higher yields are associated with LOWER durations. You can see this using any diagram of the option-free bond with price on the vertical axis and yields on the horizontal axis. A line drawn parallel to this relationship is duration; the line will be steeper at lower yields (Japan) and shallow at higher yields (France).

So, the opportunity cost of investing in France is not investing in Japan, where yields are lower and DURATION IS HIGHER! Therefore, it would take just a small DECREASE in yields in Japan to remove the benefit of the higher yield in France. Notice, that the spread between France minus Japan WIDENS if spreads DECREASE in Japan.

#5

No, it isn’t.

The slope of the tangent line is _ dollar _ duration (or, more broadly, money duration); it’s not (modified, or effective) duration.

#6

Hey derswap07,

We know a duration of 7 means, if rates change by 1%, prices change by 7% (inversely)

With a yield advantage of say 1.2%, we need to find out at what level of interest change, would the advantage of 1.2% be wiped out by the fall in prices to the extent of 1.2%.

1% rise in rates -> reduces prices by 7% (as stated above)

X% rise in rates -> reduces prices by 1.2% (to wipe out the yield advantage of 1.2%),

Solve for X = 1/7×1.2 = 0.1714% or 17.14 basis points.

Therefore if rates increase just by 17.14 bp, the yield advantage is lost.

Above is the basic understanding of how the formula would work.

P.S: you might also have to adjust for time periods in an actual problem (above eg. was for a yearly period).

#7

Thanks all.

#8

Hi Hitesh,

Thanks a lot for clearing it up. Now it’s very clear and I can do it on the exam.