At first, thought I understood some of the relationships before but after I thought more recently, guess I never figured them out completely. Hope someone can answer my questions below. Really appreciate your help!!!
My questions:
1.If the yield curve is upward sloping , the yield/YTM of the risky bond is going to be higher, right?
Does higher credit spread mean a higher yield/YTM of the risky bond?
A question lists credit spread is about to narrow but the yield curve is upward sloping. I thought credit spread is the difference between the risky and risk free bond. If it is about the narrow, the yield curve need to slop downward, right? Any insights on this?
When the economy is strong , credit spread will narrow, interest rate will be higher and yield curve is upward sloping, right?
I’ll have a go. If there is mistake, plz provide feedback…
Yield curve is upward sloping, means short-term interest rates are lower than long-term interest rates. We may therefore assume that current interest rates are low, therefore YTM of risky bonds should be lower. If the yield curve shifts upwards, then YTM is higher…
Yes. It also means that the bond has become more risky to hold.
Credit spread has nothing to do with yield curve. Yield curve relates to the risk-free return and applies same to all bonds. Credit spread relates to the risky return [u thought right] and applies differently to each corporate bond (i.e. each corporate bond will have a different spread). Upward sloping yield curve means short-term rates are lower than long-term rates. So, currently interest rates are low. The combination of low interest rates and narrow credit spread will cause corporate bond prices to rise.
When the economy is strong, credit spread will narrow, [short-term] interest rate will be higher and yield curve is upward sloping will flatten. Short-term interest rates will increase, while long-term interest rates will remain the same, so yield curve will flatten. Yield curve may also invert if short-term interest rates increase at higher level than long-term interest rates.
Thanks so much!! A lot more clear than before! I think I am getting there. A couple of follow up questions if you don’t mind.
When yield curve is upward sloping, why is the YTM of the risky bond lower? Is it related to the shorter rates all the time? Why can’t it be related to the longer term rates? Also, will the Treasury YTM lower as well?
Another question lists that a positively sloped yield curve with short rates rising 50 bps and long rates rising by 75 bps - > yield curve steepen, then we need to shorten duration in Treasuries because rising yields will cause security prices to fall. So, I guess
a. we need to shorten duration of risky bonds as well since we want to lower duration?
b. maybe shorter duration of risky bond more than the Treasury since their duration is higher than Treasury?
c. if the yield curve is downward sloping, yield curve could still steepen, right? If so, I guess we need to shorten duration in Treasury and/or risky bond?
This is how i think the process. When the Fed is changing interest rates, it is most likely referring to short-term interest rates. Logically the Fed cannot control long-term interest rates, and thus can only control short-term interest rates. Because the Fed cannot control long-term rates, it can be assumed that long-term interest rates will remain stable, and therefore YTM is unrelated to long-term interest rates. Actually, it is more correct to say that the YTM of risky (and riskfree) bonds is lower when the yield curve becomes more upward sloping (steeper). A steeper yield curve is the result of lower short-term interest rates while the long-term rates are stable. Lower short-term rates means lower YTM for either the risky or riskfree bond.
Your statement is correct, because the yield curve has shifted upwards, although not in parallel
a. Correct
b. you can shorten duration for both Treasuries and risky bond in any combination, as long as the net effect will decrease the target portfolio duration. If you decide to shorten duration for Treasuries only to reach the target portfolio duration, the resulting portfolio will be subject to future unfavorable changes in credit spread as you remain exposed to risky bonds. I dont think the duration of risky assets is always higher than Treasury, because duration does not reflect credit spread (I may need to look deeper into this)
c. Initially yield curve is downward sloping, means it is inverted, means short-term rates are higher than long-term rates. If yield curve steepens, wow thats an inverted steepening yield curve, never heard of it. For the sake of further knowledge, let assume the inverted yield curve steepens further, that means even higher short-term rates which means, u r correct, we need to shorten duration in Treaury AND risky bonds.
Great information!! Thanks for your help! Very helpful! I think I understand the relationship between short term and long term as well as relationship between between credit spread and interest rate. Just want to confirm last a couple of things you mentioned if you still have time.
if the yield curve does not steepen but just slopes upward, I guess we don’t need to change the duration of the bond if the c redit spread stays the same as well?
“it is more correct to say that the YTM of risky (and riskfree) bonds is lower when the yield curve becomes more upward sloping (steeper).”
a. the lower shorter rates -> shorter discount rate which in this case is the YTM of risky and risk free bonds, right?
“because the yield curve has shifted upwards, although not in parallel”
b. So I guess when we talk about bond and yield relationship, we mean the general yield (average yield instead of just on the short term), right? Because if we look at shorter term, the yield is lower during upward sloping steepen but the yield curve shifts upward which causes the yield to go up.
In the Econ section,
a. it states in the Early upswing stage, ST rates increasing, LT rates bottoming or increasing. I guess here is when the yield curve might flattern, right?
and then in Late Swing , both ST and LT rates increasing, this is the stage where the normal upward slope yield curve is?
In slowdown stage , ST and LT rates peaking and then decline-> fattening again?
a. Correct, both types of bonds discounted at lower rates will have higher value
b. Correct
Econ (We are going to have to speculate at this stage)
Early upswing: u are confusing long-term interest rates with yields of long-term corporate bonds. Yields of long-term corporate bonds will stabilize/increase, not long-term interest rates. But u r right when saying that the yield curve will flatten because short-term rates are increasing. Short-term rates are modestly rising while credit spreads are decreasing (because the economy is gaining momentum and business confidence is up). The net effect will be ambiguous because rising rates will increase bond yields, while narrowing of spreads will decrease bond yields, hence bond yields will stabilize/increase, as stated above.
Late swing: same confusion as above. Short-term interest rates are rising to control inflation. Credit spreads are widening as economy is overheating. The net effect will increase yield of corporate bonds.
Slowdown stage: Short-term interest rates are high and rising at first but then may peak. After the peak, the rates will fall, causing bond yields to fall (assume that credit spreads have also reached a peak too and wont widen further) and bond prices to rise.
Man, this is good!!! Can’t say how much I want to thank you. I think I am having a lot better understanding on this topics now! I will ask two last questions on this topics. Already took you a lot of time. So if you need to study other things, don’t worry about this!
a. I see. they meant long term rates of the bonds not long term interest rate in general. Then, does it mean long term interest rate typically like 30 year Treasury bond yield? Long term bond yield will be higher than that because we need to add all the risk premiums?
b.what does it mean every bond has its own yield curve?
c. And the yield curve we discussed before is based on risk free bond which is a good indicator of the economy trend and benchmark for fixed income strategy. But the short term bond yield (no matter how risky they are) will be the same or close to the shorter term rates in the yield curve based on risk free bond, right?
Then, in the Non Life section,
When they talk about the underlying cycle. “As claims on these policies are made, profits turn to losses…, taxable bonds become more attractive than tax exempt bonds.The less steep yield curve for taxable bonds provide less incentive to extend asset duration, and asset duration is likely to decline.”
a. Guess they indicate again any bond can have its own yield curve, right?
b. Also, I have question about this statement. Do they mean less incentive to extend taxable bond or tax exempt bond? Since taxable bond has higher pre tax yield, that means higher duration, right? So, if they try to reduce the amount of duration, they can reduce both taxable and tax exempt bond duration here, right?
1.a. I have absolutely no idea how long-term interest rates work, so i’ll leave this part to your imagination!
1.b. I’m not sure this statement is correct. I vaguely recall from L1, a “3D yield curve” that represents the market, which therefore possibly represents all bonds. I could be wrong too
1.c. I think… *1min uncomfortable silence* Nevermind…
2.a. And… I still dont know how to answer you…
2.b. I hate paying taxes, and i hate studying taxes!
All that jazz is pretty clear except how deflation negatively affect cash & equivalents as stated in material. I thought “cash is the king” is wide catchword during economic crisis.
Thanks a lot for your help! I think I know enough on this topics to handle the test now. Really appreciate all your help!!! At first, I was confused by some of the concepts but after all the discussions, I am clear now.
It is just your detailed answers pulled my curiosity level up again and again.
Thanks again for all your help and good luck on the test!