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.
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.