Hello I’d be extremely grateful if you can provide some clarity on this Fixed Income point I don’t understand. PAGE 69 in Volume 4 of the CFA Curriculum textbook. The second paragraph under Section 4 on p69 states that as primary supply decreases, “secondary traders lose reinforcement from the primary market and tend to reduce their bid spreads”. I’m reading this to mean as when PRIMARY SUPPLY DECREASES: - secondary spreads decrease, so secondary returns decrease, and secondary bond prices increase - primary spreads increase, so primary returns increase, and primary bond prices decrease Is this correct? If not, please clarify. I really need to understand the logic properly otherwise I will get lots of the Fixed Income questions wrong! Thanks heaps!
Hm. Wonder whether it is a typo in the CFAI text. The logic should be: o Unlike the fast-moving equity markets, bond markets can be very thinly traded --> isn’t an on-going pricing mechanism --> new prices from primary market giving less uncertainty --> lower spread in secondary market --> relatively stronger returns (because of more frequent price update and lower bidspread). It is therefore opposite conventional wisdom of supply and demand, i.e., more demand --> lower price. More activity in the primary market --> more liquid secondary market --> higher return in secondary . Therefore, in my opinion, the text should read: “secondary traders lose reinforcement from the primary market and tend to INCREASE their bid spreads”
the whole statement is poorly worded. the point is that in a periods where primary market issuance is declining the price for off-the-run (secondary market) bonds tend to decrease as the bid side for those bonds decline because traders are less certain of what a market clearing rate should be. This is seen most clearly in illiquid markets were small volumes of the market trade on a daily basis (i.e muni bond market, high yield corp, etc).
agree. It should either be worded “tend to INCREASE their (ask-bid) spreads” or “tend to decrease their bid” to make it clearer.
Someone advised me that the confusion lies between using the term “spreads” vs “bid spreads”. What’s the difference between “spreads” vs “bid spreads”???
In bond speak the ask spread is the margin over the benchmark that the dealer is offering the bond. For instance a GE 5 year is offered at 5YR Treasury + 80 bps. The 80 bps is the ask spread. The bid spread is the spread over the benchmark that the dealer is willing to bid the bond. For instance they may bid the 5 year GE bond at 5 YR Treasury + 95 bps. 95 bps is the bid spread. The bid-ask spread is the difference between the bid and the ask. In practice, a dealer might show a two way market like: GE 4.75% 6/15/15 5YR 95/80 So when issuance decreases, traders lose interest, reinforcement and in some cases liquidity causing ask spreads to increase, bid spreads to increase, and bid-ask spreads to increase.
Hi 1morelevel. Thanks for your explanation. Need further clarification! If you read Volume 4, Page 69, under Section 4, it very clearly states that: - as primary supply decreases, “secondary traders lose reinforcement from the primary market and tend to reduce their bid spreads” So does this mean that as PRIMARY SUPPLY DECREASES: 1) As Primary Supply DECREASES --> Primary Spreads INCREASE, so Primary Returns INCREASE, and Primary Bond Prices DECREASE 2) As Primary Supply DECREASES --> Secondary Traders Reinforcement DECREASES --> so Secondary Bid Spreads DECREASE 3) Secondary Liquidity DECREASES --> so Secondary Ask Spreads INCREASE 4) Thus Secondary (Bid-Ask) Spreads INCREASE 5) Thus Secondary Bond Prices DECREASE Thanks!