CFAI 2014 Mock PM C – Spong Q6

@vincent‌t, when economy is growing, private companies do well, which implies credit sectors do well. so their spreads contract. Since their ratings get better bonds in that area will perform better. Also we should decrease the treasury sector and move them to credit sector as the duration of credit ones is high and their price increase will be much more than the treasury ones. Hope this helps

@vincentt‌ , steeper implies that the short term rates are way lower than long term rates. consider short term (3%) and long term (9%). When text says steeper my conclusions would be
– Fiscal and Monetary policies both are stimulatory
– Economy is in the early swing stage and is getting back on track and inflation is decreasing.
– Credit spread will tighten

So, if yield curve is steep, we should move our money to longer duration as decreasing spread will help to gain more. On the short duration side it is dangerous as short term interest rates increase with economy getting on track. (We can still be on short term side, if our requirement is very very short term and we are managing against liabilities). So moving to longer duration is to get profits and to save losses 🙂

It’s call making stuff up @vincentt :)) No worries, just trying my best to help as well, so curiosity and full understanding is fundamental to pass. Good luck for this Sat! Remember to take some time off to nurse the brain before the big day!

@vincentt,@alta12, Sorry but I could not still get why should we increase duration of credit sector and decrease duration of treasury.
I understand that we should decrease our duration to reduce our loss. But how does this happen with the answer selected?

@vincentt, when economy is improving, short term rates rise gradually leaving further risk on the short end side until the yield curve becomes flat.

@alta12 what is your view?

@ravivooda @vincentt I did this question by process of elimination as I know I needed to long duration on credit as the spreads are coming down (and B was the only answer that fitted in my mind). Like you guys, I’m a bit confused about the steep yield curve and short duration in the treasury sector. May have to wait for @sophie for this one!

Thanks @alta12. Ok I think maybe you guys are over evaluating what the term structure of interest rate implies here.

Let me try to reason my trail of thought. When I first read the question, and looked at the answer, I knew C was eliminated given the contradictory nature of A and B.

And then I looked at statement 2 where the (credit?) spreads are expected to narrow across ALL sector. With this information, I knew I had to increase duration in the credit sector as the bond prices are expected to increase, which already points to answer B.

For treasuries, I’d only reason that it “theoretically” is the best credit rating and therefore credit spreads tightening shouldn’t affect it. In relation to point 2 and 3, I’d reallocate my exposure to credit (issuer credit risk) from straight forward Treasuries given the yield curve steepening.

I hope this makes sense?

OK @vincentt‌ @Alta12‌ – I think you guys are using the term duration in 2 meanings in these context:

1) English = a length of period (which in this case it seems like you are using the term duration to mean maturity)
2) Finance = sensitivity of bond price to yield changes

With the expected yield curve steepening (interest rate rise), reducing your (finance) duration of Treasuries at all maturity means that you reduce the sensitivity of your bond portfolio to interest rate rise, which means you reduce the impact of fall in value in your bond portfolio when interest rates increase. It is not asking about whether you should reduce exposure to short or long term maturity of Treasuries. Does this make sense?

Thanks @sophie! Makes sense now! I was thinking how to position the portfolio to take advantage of the higher rise in long term rates vs short term rates. I can see that is not what the question was asking :-/

So we cannot gain overall just lose less?

@vincentt‌ , the answer can be overweighting short term duration if we expect interest rates to rise first then later spread is decreased. This contradicts with the answer CFAI has given us. 🙁

@alta12, @sophie some help please.

@alta12, yes. Then we would move to short term end

Hello my dearest L3 candidates 😀 @vincentt‌ would you mind pasting the full question, esp statement 4? hopefully i can help this discussion

@sophie Vertex evaluates potential trades using total return analysis (TRS). TRS assesses the expected effect of a trade on the total portfolio return based on an interest rate forecast. EG. Vertex recently evaluated the expected total return for a single bond, with a beginning price of $103, a 5% semi annual coupon, an expected price at the end of one year $102.50, and an annual reinvestment rate of 2%.

Vertex also positions the portfolio to reflect the firm’s opinion on the direction of interest rates and credit spreads. Over the next 6 months, Vertex is forecasting:
1. Low and stable implied interest rate volatility
2. spreads to narrow across all spread sectors by 25bps, and
3. A positively slope yield curve with short rates rising 50bps and long rates rising by about 75bps.

Q: Given Vertex’s forecast above, the most appropriate strategy for Vertex is to:

A) Shorten duration in the credit sector and lengthen duration in the treasury sector.
B) Lengthen duration in the credit sector and shorten duration in the treasury sector.
C) Lengthen duration in all spread sectors and the treasury sector.

@vincentt , I do not remember doing such question in the text book.

@sophie @vincentt @RaviVooda‌

I’m still confused. Can we break this down.

Let’s say if the question didn’t give us 2) the bit about credit spreads and just the following:

1. Low and stable implied interest rate volatility
3. A positively slope yield curve with short rates rising 50bps and long rates rising by about 75bps.

Would you decrease the portfolio’s overall duration as the long term rates are rising more than short term rates? That way you are losing less overall on the bond value?

Therefore, there forecast were:
Credit sector -> short & long rise at 25bps and 50bps
Treasuries -> short & long rise at 50bps and 75bps

Which means it’s still an overall increase to short and long term, wouldn’t it be right to try to reduce the duration of treasuries and also credit? but more so for treasuries over credit?

Yes that certainly makes sense. But remember you’re limited to the choices in your answers. With C eliminated, and A & B remaining, the best course of action is to reallocate to credit more and reduce exposure in treasuries. Your assessment is not wrong, it’s just in the context of the answers provided. In the real world one could say you exit both the credit and treasuries play altogether! We are making a relative assessment here in the context of the answer.

And yes the credit sector is still exposed to the yield curve steepening, but with A & B remaining, I choose the answer that reduces my portfolio losses (or immunise it the most from my interest rate expectations). Hope this helps! This question ain’t easy!