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Trade 1: Sell a 3-year maturity AAA corporate bond and buy a 30-year maturity AAA bond of the same issuer based on the expectation that credit spreads will tighten uniformly by 10 bps across the credit curve.Question:
Discuss the most significant risk of Trade 1 assuming that the expectation about credit spread is correct.Solution:
The most significant risk associated with Trade 1 is that while spreads are tightening, long-term interest rates could increase (the yield curve could shift upwards). Thus, the price increase from spread tightening could be offset by the price decrease from the yield curve shift. This yield curve effect is magnified because the 30-year bond has a longer duration than the 3-year bond.My Question:
@Alta12‌ @RaviVooda‌Why is it that when spreads are tightening the long term interest rates could increase?
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Up2
@vincentt @alta12 – to price a bond, it depends on the yield curve. The yield curve is affected by a few factors, e.g.:
– current market interest rates,
– the maturity of the obligation,
– credit risk of the obligation,
– the liquidity of the obligation,
– embedded options,
– tax treatment of the obligationSo assuming everything else (except current interest rates and credit risk of bond issuer) is constant, you can see that even if the credit spread is improving for the issuer, that is not the whole story of what affects the yield curve (that affects bond prices). The long term interest rate could just as well rise and completely offset the effect of improving credit spread to cause a fall in the 30-Y bond.
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Up1
@vincentt the trade you have done is long duration trade. The question is asking given a credit spread tightening (which is really in the question to throw you off) what is the significant risk with this trade. Major risk with long duration is when long rates rise and bond price decrease. And because they mentioned the credit spread tightening, you have to link the answer back and say the loss from long term rates rise will offset the gain from credit spread tightening.
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Up0
@alta12 my answer was just “The most significant risk is interest rate risk a the 30 year bond has very long duration which is very sensitive to interest rate changes”.
not too sure if that’s an acceptable answer, but my question is regarding the solution provided by CFAI. “while spreads are tightening, long-term interest rates could increase”, is there a rule somewhere that says when short term rate falls long term rate will increase?
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