I read the example in the notes that:
If a BBB bond @spread=150 bps,an A-rated bond@spread=140bps.
If I perceive the ratings are quite close, I may buy BBB and sell the A, earning 10bps per yr.
It is then said that such thinking has flaws:
" if BBB spread remained constant while A’s spread narrowed during the investment period, the A bond will outperform BBB bond on total return basis"
What does this mean? Why this indicates that the above thinking is flawed?
you wanted a 10 bps spread pickup - so you invested in the BBB bond (bought it, and sold the A bond.).
However - if the A bond spread “narrowed” - the price increase on the A bond - given its better credit rating - would provide you with a much higher total return that the earlier Spread pickup. Had you held on to the A bond - and the price had gone the way it did - you were better off with the A bond.
So what it means is - do not make a decision only based on the current spread differential, but make an analysis based on total returns - and expectations of future movements of the 2 bonds in consideration.