From past paper: with a forecast for a stronger economy and an upward parallel shift in the yield curve evaluate whether the following trade would have a positive or negative affect on the portfolio: Buy a 10-year BB+ consumer cyclical sector bond and sell a 10-year BBB- consumer cyclical bond of another issuer. Answer: we would benefit from a potential credit upgrade and increased liquidity of the BB+ bond. The potential impact of an upgrade is more significant for lower quality bonds. Why isn’t the portfolio negatively affected overall? Since we are expecting an upward shift in yield (so a decrease in bond values), the BB+ that we bought would fall in price more than the BBB- which we sold…
Assuming same convexity and present values, the shift should not affect the portfolio, but the credit upgrades will.
It should affect it negatively overall in my opinion.
There is no mention of same convexity, same duration or same present values. Why do we assume they are the same?
Anyone able to help with why we assume the duration or convexity is the same in the above? If they are the same, then the shift doesn’t affect the portfolio, but not sure why we assume so.
I’d say with the economy improving and credit rating upgraded, even for both, it’s going to be bad. But you haven’t gave much info on this matter.
It’s somehow implied that the drop in the BBB- price would be bigger than the drop in the BB bond.
Since both are 10-year bonds, durations should be roughly the same, convexity is normally inversely related to yield. Going just by that, the better credit fundamentals on the BB bonds implies higher convexity, which is the only reason I can think of that produces a positive effect from _ only _ a parallel shift at that moment in time.
What makes you think that the dollar duration of the BB+ bond is greater than the dollar duration of the BBB− bond?
I think he is assuming that BB+ has a lower yield, ence it has a higher duration ( assuming its the sime time to maturity and coupons hehe).
That’s why I asked about _ dollar _ duration, not duration. The lower yield suggests a higher price, so fewer bonds.
Wikipedia actually states that in general the higher the credit rating the less convex and volatile a bond’s price.
The relationship between convexity and volatility is not that straightforward, volatility goes down the higher the interest rates, and goes up the lower the interest rates. It’s a function of the slope of the tangent at any given point in time. I also fail to understand how a higher credit rating would imply less convexity.
I think the main point is what will be the net effect of the trade. For example If the BBB- bond would decrease the portfolio by 1.0% but the BB+ bond would decrease the portfolio by 0.9% then the trade would have a positive net effect.
I think we know that by now.
The question was, how would an upward shift of the curve in light of an improved economy, provide a bigger downside to the short position than the long position.
MrSmart, I see what you’re saying and I think that would be hard to judge without any numbers for the durations or convexity. I read the question is that we are getting rid of the BBB- not shorting it.
Take a step back and look at what was provided. Economy is improving. These are consumer cyclical assets, so their prospects are positive in this environment.
A lower rated securitiy has more potential upside, as said in the answer, given there are more levels of ratings for a potential upgrade. The duration and convexity levels are not needed. They are more sensitive Think about a $50 stock going to 100, or a $75 stock going to 125… Lower priced (“rated”) gained +100%, while the latter gained just +67% although both grew by same value of of 50. That is a different asset class completely but my point is to think of low quality and high quality and sensitivity.
I think the biggest thing here is spread duration. Better economy = spreads tighten => lower quality bond gains more than shorting higher quality bonds loses.
You haven’t said anything new that wasn’t added before.
Which brings us back to square one.
@Mr.“Smart”
I reiterated the key points because clearly you are not getting it and given you are asking for help, I was trying to provide it. Similar to other posts sorry that you are confused/unappreciative of assistance but maybe reread this: _ I think the biggest thing here is spread duration. Better economy = spreads tighten => lower quality bond gains more than shorting higher quality bonds loses. _
You should go back to the question.
Sorry still unsure here. If we expect an upward shift in yield curve, the BB+ that is bought falls mor than the BBB- which was sold. Why isn’t the portfolio negatively affected?
jmaldonado is right. As the answer stated, it has nothing to do with convexity or duration, it’s basically just a trade to pick up more yield in an improving economy. If you have to make assumptioins for a question, then you’re probably going about it the wrong way.
I get that the improving economy means we can pick up yield since the BB+ that we bought will increase in value. But question stated that there is also an upward shift in yield, so the BB+ that we bought will decrease in price more than the BBB- that was sold, hence overall negative effect. Or is this question focussed only on the yield and not price?