If you have a bond with a current spread of 78bps and you compare this to a lower interpolated spread of 68bps, is the bond over or under valued?
The interpolates spread tells you what it should be paying.
If it’s paying a higher return than it should be, is it overvalued or undervalued?
On this basis, I would say overvalued? The question comes from an IFT mock paper and the solution concludes:
The issue has a spread of 78 bps, which is higher than its interpolated value. Hence, based on its credit spread, Bond I appears to be attractively valued.
I can understand why if you have a bond that is worth more than it the underlying model predicts that this is attractive but does this not point to the fact that it is overvalued?
Let’s try an analogy.
A wallet has a market price of $50. If it contains a $100 bill, is it overvalued or undervalued? Put another way, when you buy it for $50, do you feel that you’re paying too much or too little?
Ok now I’m going to with the bond would be undervalued based on this analogy. I would say you’re paying to little for the wallet. So am I correct in concluding that if the interpolated spread is lower than what your bond’s actual spread, the bond is undervalued and this is beneficial as getting more spread than what the interpolated spread suggests you should get?
The extra 10bp is the $100 bill. You’re paying for only 68bp of spread, but you’re getting 78bp.
Thanks so much for this - much clearer now as to how I should think about this