The following are the yields on various bonds. The relevant benchmark is that of the bond sector. Treasury Bond Yield 3.00% Bond Sector Yield 3.25% Comparable Bond Yield 5.75% ABC Bond Yield 5.50% Is the ABC bond undervalued or overvalued and why? Using relative value analysis, the ABC bond is: A) undervalued because its yield is less than that of Treasuries. B) undervalued because its spread is less than that of comparable bonds. C) overvalued because its spread is less than that of comparable bonds.
C?
ABC Bond yield - 5.5%, Bond sector yield = 3.25%. So bond ABC will be undervalued relative to the comparable bonds. B?
C?
The purpose of relative value analysis is to determine whether a bond is fairly valued. The bond’s spread over some benchmark is compared to that of a required spread to determine whether the bond is fairly valued. The required spread will be that available on comparable securities. In this example, the relevant benchmark was the bond sector. The spread for ABC bonds over the bond sector was 2.25%. The spread for comparable bonds over the bond sector was 2.50%. The lower spread for ABC bonds means that they are relatively overvalued (their price is high because their yield is lower).
I got this one right, by my logic was a comparable bond offered a higher yield, thus ABC was overvalued. Supporting LOS Info Relative value analysis of bonds involves comparing the spread on the bond (over some benchmark) to the required spread and determining whether the bond is over or undervalued relative to the benchmark. The required spread is the spread available on comparable securities. In simple terms: Undervalued (“cheap”) bonds have spreads larger than the required spread. Overvalued (“rich”) bonds have spreads smaller than the required spread. Properly valued (“fairly priced”) bonds have spreads equal to the required spread.
You have to step back for a second and think, if I am looking at a list of bonds, and one has a higher yield than another comparable bond, and there are no options, which one would I buy?
To extend Ali’s intuition: lower yield = higher price. ABC bond was prices higher than comparables which indicates it is overpriced (rich in parlance).