If the portfolio manager expects spreads to narrow for all of the spread product sectors, he or she should underweight the allocation to Treasuries and overweight allocations to the spread products, i.e., Mortgage, Asset-backed, and CMBS sectors. Why is this ?? I dont get it … This is what i make of it – Is the below correct ? Spreads go down …prices go up …callable prices go up more than non-callable –
spreads go down so you want to take on more risky securities as they will gain more than their more credit worthy counterparts.
Rudeboi, you answered your own question… Spreads decrease = Interest Rate Decreases = Bond Prices Increase, so you want to buy the spread products…
but the spread products exhibit (-) convexity …wont the prices be depressed
Yes they do at a certain point…lower coupon spread products have less Negative Convexity than Higher coupon spread products. Thank about it. If you have one MBS with a Coupon of 3% and one with a coupon of 7% and Interest Rates are now 10%. Interest rates can decline to around 7% until the 2nd MBS starts exhibiting negative convexity but they will have to fall closer to 3% before the 1st MBS security starts to exhibit negative convexity.
Ok i guess u inderstand that part - now why wd you overwight treasuries if you expect the spreads to widen ? If the rates are goin up wont the spread products do better than the noncallable ones ?
Spreads relate to the bond’s price as yield relates to bond price I.e. Tbond yield + Spread (For nominal for expositional purposes). Just as price and yield are negatively related, spread and price are negatively related. Think about it like this: Yield, Goes up => Price Goes down Yield (=Tbond yield + Spread), goes up => Price Goes down So if the Tbond yield stays static and spreads move in, the price goes up and it’s a profitable transaction.
Spreads are independent of interest rate risk.
Widening credit spreads usually means there’s a recession or contraction occuring due to an economic slowdown. If you expect credit spreads to widen, that would mean that spread product prices are expected to drop. As a result, overweight treasuries. With respect to spread narrowing, I’m still puzzed by wanting to overweight MBS. I get that a bond with a lower coupon will exhibit less negative convexity than those with higher coupon bonds but are we saying that MBS products generally have lower coupons relative to other spread products? The original poster specifically had the statement that when spreads are expected to narrow, one should overweight MBS. With the value of the pre-payment option rising during narrowing credit spreads, wouldn’t people be better off with other spread products? Unless of course the assumption is that you’re buying right at the maximum point of the credit spread where MBS are essentially exhibiting positive convexity. PJStyles
Widening credit spreads usually means there’s a recession or contraction occuring due to an economic slowdown. If you expect credit spreads to widen, that would mean that spread product prices are expected to drop. As a result, overweight treasuries. but wd’nt treasuries prices drop too ??
people flock to treasuries b/c they are safe and that bids up the price and decreases the yield…
Agree with James. Spread could narrow for a host of reasons that doesn’t effect pre-payment. For ex: rating upgrade, expectation of IR volatility decreasing, etc. In these situations narrowing of spread isn’t followed by more prepayment: -ve convexity doesn’t really matter in that case. To answer the question, it’ll be wiser to lock in the higher yield before the spread narrows.
when we refer to spreads widening or narrowing is it implied that the yield on treasuries does not change ? i.e like james said above it is static ?
ok …phew …got it . This was beginning to really bother me …thx guys !!