I am going over the alternative investment section in schweser and I came across a sentence where it seems to be a bit odd to me. I was wondering if someone might be able to help me out with this. Book 4 Page 102 it says “A fund might go long a corporate bond and short a Treasury bond, thereby earning the difference in yields. However, these funds can suffer large losses if the yield on the risky bond rises while the yield on the Treasury falls.” I might just be a little confused but I don’t see why the second sentence corresponds with the first.
With the trade described, you are effectively anticipating the market or credit conditions will maintain or even improve and the spread of the corporate will stay or narrow to the tsy. If there are adverse market credit conditions, you could get hurt on both sides of the trade,the corporate spread blows out, which you are long of, with higher a yield, this can lead to a flight to quality, where money flows into tsys, this reduces the yield of the bond you are short of,so the trade hurts on both sides. Just to say, this is where theory totally falls down in these books,it’s all very well to mention the yield difference in the bonds, but probably the most important aspect of the spread trade between the tsy and corp, is the cost of funding or repo of the bonds, which would decide of it was a winner or loser, something that doesn’t get mentioned in the texts…
an investor might think this particular corporate bond is undervalued and this bond’s yield could converge to its benchmark tsy yield as firms’s financial condition improves. so he buys corporate bond and sells tsy bonds hoping to make money as spd (corporate bond yield - tsy yeld) narrows. Next day, big catastrophic event took place (ie. lehman files bankruptcy) and people moving their money from risky asset (ie. selling corporate bond) to riskless asset (ie. buying tsy). This investor just suffered large loss on his earlier trade. hope this helps
Wait sorry I am a bit confused here why would people move to tsy when the yield of a risky bond increases? I mean I understand what gangsta is saying about if a risky bond fails people will move into risk free bonds but I think the question is asking otherwise. I think I just don’t understand why money would start flowing into tsy if the yield increases on a corporate bond ?
If there is a crisis or uncertainties in the market, then normal investor would take money out of the risky asset (ie, stocks, high yield bond, etc) and move it into most secure, safest, liquid investment out there (US treasury being one of them). This is called flight to quality. Most of the time, people sell their risky asset and buy the shorter term tsy bills and notes. so typically, tsy curve steepens and 2yr swap spread widens. After lehman collapsed, bills traded at negative discount rate (pay us gov’t to hold their money foregoing accrued interest).
But the condition here is “long risky and short tsy” and yield for risky increases doesn’t that mean people would typically move the money to risky from tsy ?
In a financial crisis, momentum trades tends to dominate over RV trades AT LEAST for short term. if you long risky and short tsy, and yield for risky increased while yield for riskfree didn’t, then you just suffered a MTM loss (unless your classified your security as HTM).
Wayne1106 Wrote: ------------------------------------------------------- > I am going over the alternative investment section > in schweser and I came across a sentence where it > seems to be a bit odd to me. I was wondering if > someone might be able to help me out with this. > Book 4 Page 102 it says “A fund might go long a > corporate bond and short a Treasury bond, thereby > earning the difference in yields. However, these > funds can suffer large losses if the yield on the > risky bond rises while the yield on the Treasury > falls.” > > I might just be a little confused but I don’t see > why the second sentence corresponds with the > first. Let’s say both corporate bond and treasury have face value of $100 and zero coupon. You buy corporate bond at $60 and sell treasuries at $90 hoping that you will earn the yield spread. However, if the treasuries yields fall (e.g. treasuries go up to $95 just due to that, not time) and corporate yields go up (e.g. corporate bond goes down to $40), you will be losing $5+$20 = $25. does that help?
maratikus Wrote: ------------------------------------------------------- > Wayne1106 Wrote: > -------------------------------------------------- > ----- > > I am going over the alternative investment > section > > in schweser and I came across a sentence where > it > > seems to be a bit odd to me. I was wondering if > > someone might be able to help me out with this. > > > Book 4 Page 102 it says “A fund might go long a > > corporate bond and short a Treasury bond, > thereby > > earning the difference in yields. However, > these > > funds can suffer large losses if the yield on > the > > risky bond rises while the yield on the > Treasury > > falls.” > > > > I might just be a little confused but I don’t > see > > why the second sentence corresponds with the > > first. > > Let’s say both corporate bond and treasury have > face value of $100 and zero coupon. You buy > corporate bond at $60 and sell treasuries at $90 > hoping that you will earn the yield spread. > However, if the treasuries yields fall (e.g. > treasuries go up to $95 just due to that, not > time) and corporate yields go up (e.g. corporate > bond goes down to $40), you will be losing $5+$20 > = $25. does that help? I understand your example but then aren’t you somewhat saying that yield = interest rate ? sorry fixed income has always been my weak point and I get confused a lot. I guess my confusion here is why would treasuries price go up when its “yield” falls (since yield is % of return from the investment)
O thank you guys I think i get it i got the yield and bond price relationship confused thanks sooo much !