Widening Spreads

**This question is from the 2008 Sample Essays** Question 5 presents the following scenario: - Widening Credit Spreads - Declining Interest Rates (Parallel Shift) The following action is then presented: Buy 7-year Ba2/BB industrial corporate bonds; Sell 7-year Baa3/BBB industrial corporate bonds. CFAI states that the above action would have a NEGATIVE impact on the portfolio due to the increased spread widening of the junk bonds. Am I missing something obvious? We are selling the junk bonds, and their spreads are widening more than the HQ bonds – Thus, their price is going down more. Isn’t this the exact reason we would want to sell those and purchase the HQ bonds?

the junk bonds BAA3/BBB bonds credit spread is increasing. Interest rate is falling as well. So the bonds are going to get higher priced. are you going to be able to find a buyer (due to illiquidity) for the junk bonds which are now getting higher priced? without being able to sell them - if you buy bonds that are going to be higher priced as well (due to the falling rates) - you will be spending more as well. so both ways you are getting hit… (not sure if this is the answer).

Think you may be reading the ratings wrong. BBB>BB

always got confused with that… thanks jmac.

as do i!

If rates are falling and spreads are widening, it means that investors are buying treasuries and selling corp bonds (as credit of corporate bonds is deteriorating). So if I am holding two bonds, one junk and one investment grade, the correct trade is to sell the junk bond and buy the investment grade bond because the junk bond will fall more in price (due to higher credit risk).

mik82 - I follow your logic completely - the junk bonds will fall in value more than the corporates. That being said, if you had to choose between Positive and Negative for the overall impact of the trade, wouldn’t you argue that your trade has a positive effect on the portfolio?

Yes, the trade that I have explained would have a positive impact on the portfolio. So going back to the original question, buying the 7y BB (Junk) and sell 7y BBB (Inv Grade) will have a negative impact on the portfolio because the Junk will fall more in price than the Inv Grade because spreads are widening and the Junk has more credit risk. The opposite is also true, if spreads are narrowing, then credit is improving so I will buy the lower rated bond and sell the Inv Grade bond. I think that’s the correct explanation, but other inputs are welcome.

Got it now. Thanks for all the help mik82 and jmac01 (you were right, I was backwards).