There are a few formulas re: Excess Spread (ES) in the curriculum but not a lot explanation of the concept itself.
Spread0 − (EffSpreadDur × ΔSpread) − (POD × LGD)
My question: In efficient credit markets, if ES is really an indicator of relative value, why wouldn’t Excess Spread just always be the same across every bond in the market?
If Bond ABC has higher ES than Bond XYZ, the curriculum suggests that bond ABC should be chosen, all else equal. So either efficient markets arb away that excess spread differential, or the differential is reflective of some other risk inherent in the bond. Or the markets are very inefficient due to liquidity etc.
Appreciate any thoughts