Portfolio Management

CFA Level II Portfolio Management
#1

Qns: which bond is most likely to recommend as the short position ?

Economic Sector

Debt/Capital

Enterprise Value/EBITDA

Spread to Treasuries (bps)

Credit Rating

Bond 1

Pharmaceutical

52.2%

7.2

255

Baa2

Bond 2

Consumer Discretionary

48.3%

7.8

220

Baa1

Bond 3

Soft Drinks

32.3%

8.5

210

A3

Ans is Bond 2.Reason:Bond 1 is in a non-cyclical industry, unlike Bond 2, which is in a cyclical industry. Bond 1 has a slightly higher debt-to-capital ratio than Bond 2 but not material. Bond 2 has a relatively tight spread compared with Bond 1. These factors suggest that Bond 2 is a better candidate for a short position. Dun understand the reason for the tight spread part. My answer is Bond 1 due to its lowest credit rating (thus largest spread to Treasuries), highest Debt/capital ratio and lowest Enterprise Value/EBITDA. Can anyone highlight if my understanding is incorrect & why Bond 2 with tighter spread is more suitable for shorting in this case? Pls enlighten. Thanks.

#2

I think tighter spread means that when **** hits the fan, the magnitude of the upward movement of the spread will be more than the one with higher spread to begin with, hence the price drop in the bond will be greater than the other.

That’s just my guess. Anybody else?

#3

cyclicality could be the reason for the short position

#4

Thanks alot guys! It has been very helpful!