breakeven spread analysis

[RoccoLee]

When calculating for the breakeven spread,

breakeven spread = yield difference / duration,

should we always choose the higher duration? If yes, why we need to do so?

Will it be more logic to calculate as below?

breakeven spread = yield difference / difference of duration

[cpk123]

You want to use the higer duration because that can expose the price change more quickly. Movement in price can cancel out the yield advantage of the higher-yield bond given the movement in interest rate.

higher yield bond - likely is going to be the lower priced of the two bonds too. So you would be buying up the lower priced bond - thus costing you less as well.

But note that this question could very possibly be asked as what should you do with a particular BOND as well. In that case - that bond’s duration only should be used.

Another common twist - they give you annual rates - ask you to calculate the amount of bond required for a quarterly increase in yield (quarterly change in spread)…

[RoccoLee]

@cpk123

You want to use the higer duration because that can expose the price change more quickly. Movement in price can cancel out the yield advantage of the higher-yield bond given the movement in interest rate.

higher yield bond - likely is going to be the lower priced of the two bonds too. So you would be buying up the lower priced bond - thus costing you less as well.

But note that this question could very possibly be asked as what should you do with a particular BOND as well. In that case - that bond’s duration only should be used.

Another common twist - they give you annual rates - ask you to calculate the amount of bond required for a quarterly increase in yield (quarterly change in spread)…

About what should you do with a particular BOND, I understand that when interest rate is expected to increase, move to the bond with shorter duration.

But how to calculate the amount of bond required for a quarterly increase in yield (quarterly change in spread)? Could you give me an example, please?

[cpk123]

look at the book for examples … read in the white material between blue boxes. there are examples there - and if I recall right - there was at least one example in the EOCs.

[RoccoLee]

@cpk123

look at the book for examples … read in the white material between blue boxes. there are examples there - and if I recall right - there was at least one example in the EOCs.

I just checked the notes and CFAI materials, there is only one example that illustrating how to calculate the breakeven spread analysis.

Could you kindly tell me the twist you mentioned, please? Thanks a lot.

[RoccoLee]

@daharmattan1

Let’s say we have a foreign bond with a 50 bps yield advantage over a domestic bond. The foreign bond has a duration of 6, which is the longer duration, and our intended holding period is 3 months. What is the breakeven yield change?

The foreign bond has an annual yield advantage of 50 bps, but our first step is to convert the annual advantage to the advantage relevant for our three month time period.

In this case that’s every quarter or every three months so it is a 50 ÷ 4 = 12.5 bps advantage. As cpk123 said, w e always have to divide the yield advantage by the number of periods in question. From there we can calculate the change in yield required over the holding period to make their total returns equal by dividing by the negative of the longer duration. That would be 0.125/-6 = -0.021%, or just over 2 bps. Note that this reflects the spread of the foreign bond widening.

In breakeven analysis the spreads between the two bonds will always have to widen.

Much appreciated!