in schweser book 3 pages 259, I want to know why:
yield curve is expected to narrow ( widen), choose higher (lower) yield bond, and
if the yield spread is expected to narrow( widen), increase (decrease) spread duration ? thanks a lot
If the yield curve is expected to narrow, then bond prices will rise. Bonds with higher yields experience larger price rises when yield spreads narrow than bonds with low yields. This is because if yields are higher, then generally have further to fall.
With regards to the second point, spread duration measures the sensitivity of bond prices to changes in the yield spread. If the yield spread is predicted to drop, then prices are predicted to rise. The higher the spread duration, the more sensitive the bond price to a particular fall in yield spread. So we want bonds with a higher spread duration so that prices benefit more from the expected drop in spread.
I’m not sure what it means for the yield curve to narrow or widen.
Flatten or steepen, but not narrow or widen.
Indeed…I meant the yield spread 
Jesswong, Can you find out the corresponding section in the official curriculum book ? Tried to find it from the offical book, but not exactly located. Thanks
With regards to “yield curve is expected to narrow ( widen), choose higher (lower) yield bond”, S666 nicely mentioned that “If the yield curve is expected to narrow, then bond prices will rise. Bonds with higher yields experience larger price rises when yield spreads narrow than bonds with low yields. This is because if yields are higher, then generally have further to fall.”
Can someone please explain what S666 has explained? Does he mean that bonds with higher yields have longer duration?
I believe that you got this one backwards. All other things equal, bonds with higher yields (i.e., YTMs) tend to have lower modified durations than bonds with lower yields (YTMs).
For example, a 10-year, 6%-coupon, semiannual-pay bond has a modified duration of:
- 7.97 years when its YTM is 2%
- 7.44 years when its YTM is 6%
- 6.89 years when its YTM is 10%
See my post, above.
He got it backward.
But hang on, I’m not talking about the duration of the bonds, I’m talking about the relative size of the change in yield spread when it is initially high vs when it is initially low…
I wrote, "This is because if yields are higher, then generally they have further to fall.”
If the size of the spread change is significantly different, so will be the magnitude of the price change.
Sorry, if that’s the case, what does Schwser exactly means by “yield curve is expected to narrow ( widen), choose higher (lower) yield bond,” why is that so?
Dear all I’m stuck there too… took out the cfa book and could not find this Para. … can someone help? Is this a schweser error ?
Figured it out in the later readings… what schweser says is that when the economy is doing well, the difference between lower grade bonds and higher grade narrows as there are a lot of investors. Spreads are small.
When the economy is doing badly (recession) these spreads widen as lower quality issuers need to pay investors more highly.
So if you are looking for excess returns and if you expect the economy to do well you’ll go for high yield but when the economy is expected to worsen you will choose the bond with the lower yield (flight to quality)
Schweser says that there is an implicit assumption that portfolio duration should be kept the same.
also to add, directly from CFAI text under Total Return Analysis (Relative Value Methodolgies reading) it says “Economic prosperity usually leads to tighter credit spreads and boosts credit returns relative to Treasuries” - hence higher yielding credit/corporate bonds should experience larger Total Return under narrowing spreads, compared to Treasuries (and vice versa - ie. perform worse when spreads expand).