John Black, an analyst at XBK, shares Goodwin’s view that spreads should tighten over
the next year. Black has identified three bonds in Exhibit 1 in the industrial corporate
sector as possible investments. Black expects spreads to tighten by 30% for all three
bonds.

Determine which bond most likely provides the highest expected excess spread
return based on Black’s expectation (Bond 1, Bond 2, Bond 3). Justify your
response.

The solution for bond 2 and 3 is
Bond 2 = 7.44% = 2.25% – (8.00 × (– 0.68%)) – (1.00% × 25%)
Bond 3 = 7.04% = 4.30% – (3.75 × (– 1.29%)) – (3.50% × 60%)

Where is 0.68% coming from? Shouldn’t the change in spread be 0.3%? Not getting this.

By “tighten by 30%” they mean the the new spread will be 0.7 (= 1 − 30%) times the existing spread, so the change will be 0.3 times the existing spread:

225 bps × 0.3 = 67.5 bps ≈ 68 bps.

I hate questions written like this.

They’ll do better on the exam.

(By the way, 0.3% is not 30%.)

Spreads tighten by 30% (percent) → current spread × (1 - 0.30)