Except of Ex 10 R14:
Corporate versus Government Bond Roll Down
A London-based investor wants to estimate roll-down return attributable to a fixed-rate, option-free corporate bond versus UK gilts over the next six months assuming a static, upward-sloping government yield curve and a constant credit spread. The corporate bond has exactly 10 years remaining to maturity, a semiannual coupon of 3.25%, and a YTM of 2.75%, while the closest maturity UK gilt is a 1.75% coupon currently yielding 1.80%, with 9.5 years remaining to maturity.
- Calculate the annualized roll-down return to the UK corporate bond versus the government bond over the next six months.
2. Describe how the relative roll-down return would change if the investor were to use an interpolated government benchmark rather than the actual 9.5-year gilt.
Solution to 2:
The interpolated benchmark involves the use of the most liquid, on-the-run government bonds to derive a hypothetical 10-year UK gilt YTM. Because the UK gilt yield curve is upward sloping in this example, we can conclude that the relative roll-down return using an interpolated benchmark would be lower than the 0.95% difference in Question 1.
Can anybody explain why the relative roll-down return using an interpolated benchmark is lower than the difference in Q1? The CFAI text does not seem to explain why
Thanks in advance.