Is Cyclical Changes and Scarcity Value saying the opposite? Question 4a on page 89 of CFAI volume 4 says that new issues will trade at a premium (narrower spreads) due to their lack of supply, where as cyclical changes in schweser says heavy supply cause narrower spreads because new issues validate old ones?
Narrow spreads CAUSE Issuers of bonds to come to market, as more Issuers come to market this will CAUSE spreads to widen as the market becomes flooded.
I find it’s easiest to think in terms of why issuers are flooding the market and what happens when they do. for Instance: If spreads are narrow, prices are high - meaning an issuer selling a bond will get more money for the issue. This causes them to issue more bonds. As more bonds come to market, secondary traders selling/buying similar bonds from the same issuer use the market prices to vailidate their bonds’ prices. With greater supply in the market now, prices begin to fall and spreads widen.
It really is a process of one thing causing the next and if you follow this through logically it makes sense.
Thanks FinNinja , makes a lot of sense.
supply and demand linked to scarcity value.
cyclical changes ( recessions , expansion etc ) linked to bond market in general ( all issues , new and old ).
I can understand how one may lead to another but are independent of each oter
So do I understand correctly that in normal circumstances, a heavy supply will cause spreads to widen, but that is different in the new issue market. Because there heavy supply will cause spreads to narrow and issue to trade at premium because investor use new issue to validate prices (eliminating price uncentainty) , and require less spread. I think I am mixing up the concepts. Please help?
As Fin suggested i think it’s like one thing following another
If spreads r narrow---->prices are high----> many new issues----->issuers can profit from high prices---->scarce issue will also rise in the secondary market as well—>as supply increases—> spread widen again
Cyclical changes---->Recession/expansions---->in expansion—>spread narrows—>prices are high…then the same cycle again…
How come these are independent of each other. Confusion?
they are independent because the 2nd part - the cyclical changes (recessions / expansions) you do not control. It is something that happens whether or not the other process of new issuances and spread narrowing / widening happens or not.
^ thanks!