Topic Test Quantum (Portfolio Management)

CFA Level II
#1

Q4 asks which sector would be best for a short position given the economic forecast of lower GDP.

i chose the answer with the tightest spread (option 3) - Answer is Option 2 - a BB rated discretionary staple firm. Why is this the case? My thinking was that if the GDP is forecasted to fall we want to protect by going for tighter spreads as opposed to more risky? Or is this something to do with the fact we are shorting?

Answer below:

Bond 1 is in a non-cyclical industry, unlike Bond 2, which is in a cyclical industry. Bond 1 has a slightly higher debt-to-capital ratio than Bond 2 but not material. Bond 2 has a relatively tight spread compared with Bond 1. These factors suggest that Bond 2 is a better candidate for a short position. During an environment in which GDP is forecast to surprise to the downside, higher-rated issues, such as Bond 3, are likely to outperform. Given Quantum’s expectation for declining GDP and its relatively tight spread, Bond 2 is the best candidate for a short position.

#2

I am with you on this one - I messed it up too. Tightest spread doesnt necessarily meant it will be the best bond for a short position because the tight spread is justified because bond 3’s credit quality is A3 as opposed to the other bonds which are lower rated (Baa2/Baa1)

Bond 2 had a Baa1 credit rating which is right between Baa2 and A3 which is the ratings for the other 2. Therefore the spread should be smack dab in the middle using linear interpolation ~ 232 bps. The spread was 220 therefore the spread was a bit tight. You would short bonds like this because you would expect the spread to widen to the appropriate level. Also the bond is in the Consumer Discretionary sector which should be a bit more sensitive to GDP.