Fixed Income: effect of surge in new issuance’s in a particular bond sector

Question

Hi, Somewhere in the text it was mentioned that when there are new issuance's in the market, spreads in that sector tighten as this is verifies the existing market spreads, indicating a favorable environment etc etc which is not intuitive as it is against what we will infer from demand supply analysis. I agree to this point.Again in CFA text in Practice problem 15, page 96 it is mentioned that surge of issuance by single A rated companies will blow out spreads creating buying opportunities and once issuance subsides, spreads will tighten. I am confused as again over here demand supply analysis is used. Is there something I am missing as I have not used institute material for reading? Can we have both the scenarios possible and used in exams?

mitch895 · Answer

Anyone's guess if this topic gets a run in the exam.  Is your question about the impact of secondary issuances on spreads?  If so, the reason spreads are affected is that it effects the order at which bondholders must be repaid if the company defaults.  In other words, if a company issues more bonds then their total capital is increased, which reduces risk to those first in line: this reduction in risk should tend to reduce the risk premium on their bonds (those first in line).    Of course from a market-level perspective it's counterintuitive is that you would expect that increasing supply of bonds to a market should necessitate increasing the spread (to entice investors).  (not sure if that answer the question??)