Breakeven spread analysis

in vol.4, P.149 Q8, - spread between US and German bonds is 300bps, providing German investors who purchase a US bond with an additional yield income of 75 bps per quarter. Duration of German bond is 8.3. If German interest rates should decline, how much of a decline is required to wipe out the yield advantage?

US yield is higher than German yield, shouldn’t German yield (interest rate) increase to close the gap between the two bonds?

No, the point of breakeven spread analysis is that additional yield return can be offset by capital gain on the other bond.

If the US bond has a 3 month yield advantage of 75 bps and the German bond a duration of 8.3 then a:

75bps / 8.3 = 9 bps decrease in rates on the German bond will create a 75 bps gain on the German bond and eliminate the yield advantage of the US bond.

Make sense?

75bps gain on german bond is from the price increase due to decrease in yield?

I’m unsure of what you are asking in your last post?

Does the inverse relationship between interest rates and bond prices come as a shock to you?

US bond yield is 300bps higher than German bond…

so if German bond declines by 9*4 = 36 bps per year…

then the spread between them would be 336bps???

so the spread between the two becomes bigger… so how does it breakeven?

You seem to be over thinking this.

Let’s say the US bond is yielding 10% pa ( or 2.5% for the next 3 mths) and the German bond is yielding 7% pa (or 1.75% for the next 3 mths). Now if you had bought the German bond you would be 75 bps down on the other option (the US bond). If interest rates on (only) the German bond were then to drop by 0.09% then, as we know that the duration is 8.3 (or an 8.3% change in bond price for a 1% change in yield) we know that the German bond will earn 8.3 x 0.09% = 0.75% in capital gain from the fall in interest rates of 0.09% on this bond and the total return will be 1.75% (yield) plus 0.75% (capital gain) for a total return of 2.50% and the same (breakeven) return as the US bond.

Make sense now?

your explaination should be in the curriculum… thx =D

what if i dont have the german bond in hand?


Its just meant to be an analytical technique that shows how much any given bond would need to fall or rise by to nullify a yield disadvantage or advantage. In light of this, I again don’t understand what your question is asking?

if the yields are the same for US and German bonds, there would be no yield advantage or disadvantage right??? so breakeven to me was to bring up the yield of the lower yield bond… and i forgot the price effect on the bonds… =p