Jack Hopper, CFA, manages a domestic bond portfolio and is evaluating two bonds. Bond A has a yield of 5.60% and a modified duration of 8.15. Bond B has a yield of 6.45% and a modified duration of 4.50. Hopper can realize a yield gain of 85 basis points with Bond B if there are no offsetting changes in the relative prices of the two bonds. Hopper has an expected holding period of six months. The breakeven change in the basis point (bp) spread due to a change in the yield on bond A is: A) 5.21472 bp, due to a decline in the yield. B) 10.42945 bp due to a decline in the yield. C) 5.21472 bp due to an increase in the yield.
A
A
A!
Answer is A: 5.21472 bp, due to a decline in the yield. By purchasing Bond B Hopper can realize a yield gain of (6.45 – 5.60) = 85 basis points if the yield spread does not increase. The yield advantage for the 6-month time horizon is (85/2) = 42.5 basis points to bond B. This is the yield advantage that must be offset in order to break even, hence we use 42.5 basis points in the formula to indicate the price of bond A will increase. Since we are looking at this from the standpoint of a change in yield on Bond A: (0.425/-8.15) x 100 = -5.21472, implying that the change in yield for bond A is -5.21472bp and the spread must increase by 5.21472 basis points. This change will result in capital gains for Bond A, which will offset B’s yield advantage.
agree with A. (6.45%-5.6%)*0.5/8.15 = 0.0521%
" implying that the change in yield for bond A is -5.21472bp and the spread must increase by 5.21472 basis points. " Should’nt the yield spread decrease ? Doesnt the bond price increase when when yield spreads decrease/narrow ?
The increase in spreads referred to here is between Bond A and Bond B. Bond A’s yield dropped and it’s price rises to make up for the yield advantage. In the process, it’s spread over treasuries has decreased while the spread between Bond A and Bond B has widened.