Yield advantage of a foreign bond ? What does that mean exactly : Does it mean after allowing for currency translation the yield is higher than comparable domestic bonds with similar credit risk ?
PM is trying to decide which bond to invest in - domestic or foreign. If he thinks interest rates in foresign country will increase less than what market expects, he will invest in higher yielding foreign bond since the decrease in price of foreign bond (due to increase in interest rates) will not totally offset the higher yield the foreign bond has. So, calc yield advantage and use the bond with higher duration… Change in bond price/Duration = Breakeven Yield change
But a higher yield per se doesn’t necessarily imply a shorter duration which would make it less sensitive to interest rate increases. So you’re suggesting the manager has a view on local interest rates of the foreign bond. Thanks for your help but still no quite clear about the terminology (ie yield advantage) . If the foreign bond has a higher yield isn’t that already in the price ?
Yield Advantage of a Foreign Bond simply means that the Foreign bond has a Higher Yield say 6% vs a Comparable Domestic Bond of say 5%. Now the issue is that the Yield Advantage can easily be wiped out with spread widening (not including effects from FX rates). To determine how much spread widening can occur before the advantage is wiped out is the purpose of Breakeven spread analysis.
yield advantage would be wiped out by the lower yielding bond’s sread widening? because it is currently the lower of the two spreads… this one I am having trouble with…
No, by Higher yielding bond’s spread widening. You went to the higher Yield for higher return, but if the Spread widens the bond price is going to decrease which is going to offset that increased return.
there are 2 bonds: A (domestic) with yield 5% and B (foreign) with yield of 6%, the duration of the domestic bond A is 5 The spread between A and B is 100 bps, so you go and buy bond B hoping to capture its higher yield what Breakeven spread analysis is doing it asks a question by how much the spread should widen as a result of of decline of domestic yield (in country A) to wipe your yield advantage Breakeven spread = 100 bps / 5 = 20 bps What that means is that if yields in country A decline by 20 bps, you are at a breakeven point. The decline in yields in country A didn’t realle affect your bond B, but since you spend your money to buy bond B, you didn’t buy bond A, but would you buy bond A, the decline in yields by 20 bps in country A would increase the price of bond A by 1% or 100 bps and that would produce same impact as your 100 bps yield advantage of B and you are indifferent in this situation (actually you probably would be indifferent since by buying B you have FX exposure to worry about) change in price = - duration * change in yield now if the yield in A would decrease by 40 bps, bond A would gain 200 bps, and now you are worse off because you purchased bond B and not A
question: do we have to divide by the higher duration? I notice you didn’t give us the duration for Bond B…
Yes divide by the higher duration but be careful as to what bond the question asks you to reference in terms of the yield change. I missed a Schweser Mock Exam question for that reason.
Did anyone notice that the afternoon test 2 of Schweser book 2 didn’t use the longer duration for the breakeven calculations? Does this have something to do with what bond perspective we’re supposed to use?
you can’t really say by which duration to divide it will be based on the question the way the concept is explained in CFAI, you usually use domestic bond duration to calculate the breakven point from the prespective of declining domestic yields that will eliminate your yield advantage of a foreign bond but the question, can be reversed, with duration of the foreign bond is given, and in this case foreign yields will have to increase by certain amount to wipe your yield advantage of the foreign bond in both cases the spread between domestic and foreign bond is widening. When you look at it from domestic point of view, domestic yield declines and spread widens; when you look at it from foreign point of view, foreign yield increases and spread also widens just pay attention how the question is worded and understand these concepts and you should be fine
thanks, excellent post! very helpful.
volkovv, Thank you. Great post. I was reading the CFAI text book for this part but I did not understand that well. Another thing was that last year, I remember that when this kinda q came, we did: (rtn bond fgn - rtn bond dome) - ( interest dome - interest fgn ) / higher duration something like that ( but certainly not just the difference of the bond yields) thus when the Q came out I did use these interest difference, but that part has been disappeared from the text. can you explain why ? I know I should have checked the last year’s Schweser but still have not checked.
the formula you quoted doesn’t make much sense to me, so can’t be much help with it
OK, thnx for the feedback anyway.
Ah…the value of the search engine I keep coming across Schweser saying to use the bond with the higher duration in the denominator, yet to day I did two questions from QBank and got them both wrong because of it. So, I’m now reading into this that you use the bond’s duration being directly referred to in the question (as to how much yields have to move to equate value to the other bond) and calculate the Breakeven Spread, then depending on whether the current yield is higher (lower) than the other bond, rates would have to decrease (increase) by the amount of the Breakeven Spread to equate the two bonds. For example: Bond A has x yield and a duration of (a), and Bond B has y yield and duration of (b), the breakeven change in the spread due to a change in the yield on bond B is: (assuming a one year time horizon, if less than a year remember to multiply by the fraction) (yield on bond B - yield on bond A) / Duration on Bond B So if Yield on Bond B is higher to start, then the Yield on Bond B would have to increase by the amount of the Breakeven Spread Calculation to equate Bond B to Bond A. Correct?? Does that make sense??
It makes sense to me. However, CFAI also says that you should use higher of the durations. One point that is missed is breakeven analysis is just an approximation. If you fancy a 6% coupon bond as opposed to 5% coupon bond. It makes you stop and think the total return buy a crude calculation of the probable effects of a interest rate changes in the two countries.