Yield Spread Pickup Question

Hi everyone,

Quick question here would appreciate some help.

Fixed income book, P75, Yield/Spread Pickup:

It says if a BBB rated issue trades at a 150bp spread, and a BBB- trades at a 140bp spread, you would find the rating differential irrelevant and purchase the BBB issue for a spread gain of 10bp.

My question is, shouldn’t the BBB- issue have a larger yield spread to reflect the higher risk?

Aren’t higher spreads a negative? Or does it mean the yield to maturity is higher, so you should be buying to earn more yield? And again, in this case, wouldn’t the lower rated BBB- offer a higher YTM?

Would appreciate some help here. Thank you everyone.

That _ isn’t _ what it says.

What is says is, “. . . _ some investors _ will determine the rating differential irrelevant . . . .”

A good part of the skill set needed to pass the Level III exam is careful reading and understanding.

To _ some _ investors, the rating differential won’t matter, and they’ll base their decision solely on the spread.

To _ other _ investors, the rating differential will matter; they’ll consider that along with the spread differential when deciding which bonds to purchase.


But, any idea why the BBB higher quality issue is offering a higher yield than the lower rated BBB-?

Probably the investing public doesn’t believe the ratings to be accurate.

Thanks a lot S2000! You’re really the best :slight_smile:

You’re too kind.

How can you capitalize on the credit spreads converging if you do not own a bond portfolio? What if the two bonds are in differnet industries?

If the credit spreads are going to narrow (get smaller), the bond prices will increase, so you want to buy when spreads are expected to narrow – think narrowing spreads = smaller interest rates = prices rise

It’s still not a diversified portfolio, I meant long the bigger spread, and short the smaller spread, but in a way that you’re return comes only from credit spreads moving in opposite directions, and not from other risk factors.

Let’s say a bond in the oil industry seems underpriced, while a bond in the retail sector looks overpriced, then you long the oil bond, short a bond portfolio/index on the oil industry, short the retail bond, and long a portfolio/index on the retail industry. Effectively hedging against all return and risk factors except credit spreads. Something along those lines.

the BBB- issue we sold, what happens if the yield increases? The value of the bond would go down so we would have a gain?

My confusion here is, it says Yield/Spread pickup…

Does it mean the YTM difference between the two issues, in which case the one with the higher YTM = better (offers higher return) = buy?