Schweser text says: Increases in the number of new corporate bond issues are sometimes associated with narrower spreads and relatively storng returns. A possible explanation is that the valuation of new issues validates the prices of outstanding issues, which relieves pricing uncertainty and reduces all spreads. The answer for CFAI practice problem 15a says: The manager expects that in the first quarter of 2000, there will be a surge of single-A rate issues that will come to market, resulting in a widening of spreads and thereby providing an opportunity to purchase single-A rate issues relatively cheaplyversus BBB issues. So Schweser says an increase in supply leads to narrow spreads, while CFAI says an increase in supply leads to widening spreads, why are these different?
Thanks Vsowers. Any other explanations to this?
Hi, I don’t know why i can’t see the answer of Vsowers. Maybe it has been deleted. Anyways, my understanding is that the basic rule is as follows: a change in the supply / demand equilibrium resulting from a decreasing demand or increasing supply will lead to bond prices decreasing and spread increasing (and inversely increasing demand or decreasing supply will lead to bond prices increasing and spread contracting). Now the schweser notes as you mention discuss another effect, which contradicts the basic rule. The CFAI material also refers to this effect that has been observed on the market, even saying it is counter-intuitive. It exists. But in general, the basic rule continues to apply.
To clarify: From a basic macro perspective: An increase in supply or a decrease in demand = lower prices and higher yields A decrease in supply or an increase in demand = higher prices and lower yields. But Schweser are talking about another effect, where an increase in supply leads to lower yields and higher prices. Is that correct?
Yes that’s how i understand it but you’ll find a more precise explanation here: http://www.analystforum.com/forums/cfa-forums/cfa-level-iii-forum/91338956 It seems that the economic theory does not really hold in practice, probably because it assumes ‘all other things being equal’ and they are not.