Over the next two weeks credit spreads will widen and all interest rates decline significantly. Are asked to evaluate the impact on portfolio of the following: 1. Buy 7-year BB corporate bonds Sell 7-year BBB corporate bonds 2. Buy 5-year callable corporate bonds Sell 5-year non-callable corporate bonds Answer for number 1 says: Negative overall effect since lower quality corporate bond spreads widen more than higher quality bond spreads in a weak economic environmnent due to higher risk of default. I understand that the BB bond we bought widens more than the BBB bond we sold, but why is the decline in interest rates not considered? Because the decline in interest rates should increase value of the portfolio.
topic test SPONG fixed income question 6 covers the same concept… my understanding is that “spread direction” is more important than “rate direction” for credit spreads. i think it has to do with convexity exposure
Just my two cents here, if the overall level of interest rates are falling, the value of all the existing bonds in your portfolio will increase and, therefore, this won’t impact on the decision to buy a different graded bond.
However, when you are buying a more risky bond, if credit spreads are expected to widen, the price of such a bond will be lesser than that of a better graded bond.