Spread Risk

So let me get this clear. If you hold a bond and the spread over treasury’s increases this is a negative; however, if you don’t hold a bond and the spread increases over treasury it makes these bonds more attractive all else equal? Am I on the right track here?

yes, on 1 yes, on 2 assuming spreads will tighten after you purchase the bond all else equal

Yeah, the key thing to remember about FI is that the payments are defined beforehand (barring default). This isn’t true with equities, and it make thinking about fixed income very different. The best thing to remember about FI is that changes in yield are good for some people and bad for others. It’s a bit like currency exchange rates - any change is good for some companies, bad for others, depending on a bunch of factors. Therefore, if the yield goes up, that’s great if you’ve got money in cash or somewhere else to take advantage of that new yield. Yield up is good, Mr. Cashholder! Yay! But if you already hold FI instruments, and they’re not floating rates, then yield up is bad, because the price you can get for your bonds just went down, so that anyone who buys your bond will get the prevailing rate. Yield up is bad for you, Mr. Bondholder. Boo! Now for Mr. Bondholder, it can be bad or very bad. It’s just run-of-the-mill-ordinary-bad if you’re planning to hold the bond to maturity, because you miss out on the rate increase that you might have been able to get if you had had cash available. It’s really really bad if you need to sell your bonds before maturity, because you are going to lose money when you sell. In theory you can do this kind of thing with equities too, in that the price of a stock going up is good if you already own the stock and bad if you don’t. But because the rate of return on a stock is more unpredictable, you don’t get as defined a mathematical relationship between future stock yields and current prices: or rather, with stocks, the price is used to estimate expected yields, whereas with bonds, yields are used to calculate the price.

wow nice bchadwick, thanks for the story I think I have this topic down pretty well. Until I see the crazy CFAI question on the exam.

BCHADWICK, THIS IS THE EXPLANATION I HAVE BEEN SEARCHING FOR SINCE L1, I’m not even kidding. I failed FI section for L1 and L2 but it would be nice to finally pass FI

so if yields are going up, we want to be in near cash instruments like treasuries, etc. lower yield but smaller price drop. I would assume so that we would minimize our losses (and uncertainty of losses) given credit spreads widening. I’m trying to verify why we prefer/favor Mortgage Securities and Callable bonds in times of rising yields as opposed to a purchasing non callable bonds? is it in regards to their positive convexity? Do Mortgage Securities and Callable bonds offer less uncertainty in times of spreads widening than a non callable corporate bond as well? ??

We prefer MBS in times of rising yields because the decrease in the value of the pre-payment option will help offset the drop in the value of the MBS as compared to a regular bond.

almo Wrote: ------------------------------------------------------- > so if yields are going up, we want to be in near > cash instruments like treasuries, etc. No you want to be in low (or better, negative) duration instruments. If yields go up and you are long 30-year Treasury STRIPS, you are getting annihilated quickly. > lower yield but smaller price drop. I would assume > so that we would minimize our losses (and > uncertainty of losses) given credit spreads > widening. > Also, in general the more credit risk in a bond, the less interest rate sensitive the bond is. If you own junk debt, you are probably more concerned with equity risk than interest rate risk. > I’m trying to verify why we prefer/favor Mortgage > Securities and Callable bonds in times of rising > yields as opposed to a purchasing non callable > bonds? PJStyles got this nicely. > is it in regards to their positive > convexity? > > Do Mortgage Securities and Callable bonds offer > less uncertainty in times of spreads widening than > a non callable corporate bond as well? > > ?? mortgage securities vs non-callable corporates in widening spread environment… Hmm… Rising spreads is about credit risk. If you own agency backed debt you are not concerned about credit risk (I guess…) so spreads probably don’t matter to you. If you own mortgage securities collateralized only by the underlying homes, you probably care very deeply about credit problems. Corporate bonds are all over the map from AA (Are there any normal AAA corporate bonds anymore?) to defaulted. At either extreme, you don’t care much about credit spreads but in the middle you do a lot.

Yield = PMT/Price Yield go up = price go down Remember that relationship and you should be able to figure it out

Thanks Guys! PJ - I forgot that relationship, thanks for reminding me! MGG - thanks as well, I prefer the math relationship as well, but most of the questions are of a qualitative nature, so If they don’t provide the numbers, I’m screwed! but, that will help as a proof in regards to my answer if the variables are given. Joey - if “Yields” are rising, we do want to be in Treasuries, this is stated in the curricullum in SS 8. I think that it has to do with the credit spreads over investment grade products versus non investment grade. i.e. price drops aren’t as significant in investment grade securities. (lower credit spreads) Any other opinions with respect to this? (i.e. why we overweight treasuries long term?)

almo Wrote: ------------------------------------------------------- > Thanks Guys! > Joey - if “Yields” are rising, we do want to be in > Treasuries, this is stated in the curricullum in > SS 8. I think that it has to do with the credit > spreads over investment grade products versus non > investment grade. i.e. price drops aren’t as > significant in investment grade securities. > (lower credit spreads) > Any other opinions with respect to this? (i.e. why > we overweight treasuries long term?) This is the credit spread vs interest rate debate which is pretty murky. What’s really clear is that if yields are rising you want to be in low duration things. If CFAI has a stance on credit spreads vs yields, it’s news to me.