I do not understand how this indicator works? what is high-grade bond, and low quality bond? and how to explain the following statement: during periods of high confidence, investors are willing to invest in lower quality bonds for the added yield, which causes a decrease in the average yield for the large cross section of bonds relative to the yield on high grade bonds. Therefore, this ratio of yield-the confidence index-will increase.
confidence index = yield on high grade/yield on lower grade so, when confidence is high, investors are investing in the lower grade bonds (since they are ‘confident’ these bonds won’t default), which leads to lower yields on these bonds (more demand for bonds increases price, lowers yield) hence, with lower yields, the ratio above increases.
what i did not get is when confidence is high, what happened to high grade bonds only situation on low grade bonds was provided here.
It is probably safe to assume that when confidence is high, investors are choosing the lower grade bonds over the high grade bonds. So the spread is narrowing as both the high grade bond yields increase (due to smaller demand) and the lower grade bond yields are decreasing (due to higher demand). A narrowing of this spread makes the ratio increase.