I’m really stuck on page 31 of book 3 of the schweser study guide.
Below paragraph from the study guide says:
For example, the manager might forecast a widening of the spread for one sector of bonds and a narrowing of the spread for a second. The manager would want to reduce the weight of the first sector to minimize the impact of the increase in interest rates (falling prices). He would want to increase the weight of the second sector to maximize the impact of falling rates (rising prices).
I’m sure this is really obvious, but i’m not getting the connection for some reason. In widening spreads and when rates rise and bond prices fall, why would we reduce our weight to the sector? And in narrowing spreads with falling prices and rising rates, why are we increasing our exposure to the sector?
widening spread is equal to losing money for the long in a spread sector such as corporate BBB bonds.
Price of a bond falls when its perceived risk increases as evidenced by increased spreads.
Remember that yield and price move opposite to each other . The spread is calculated as a difference in yields between a risk free instrument such as a treasury and the risky instrument generally of the same duration. So if a spread is widening , its yield is rising whch means the holder of the bond is losing on price.
okay, i think i got it. they are just saying that widening spreads are caused by increasing interest rates and falling prices, hence as a bond holder you would like to decrease your allocation to this sector because it’s becoming riskier?
also, the beginning of the quote starts with : the manager may FORECAST a widening" meaning that the widening is about to happen, but has not yet. A bond investor would always want to position themselves toward the sector that is narrowing, or widening the least.
If you think about it even if interest rates are declining, some bonds will increase in value faster than others. the goal is to over weight the sectors that will have the strongest performance - which will be the bonds whose spreads are widening the least or narrowing the most.
that makes sense. Thanks guys!