An active fixed-income manager is considering two corporate bond positions for an active portfolio. The first bond has a BBB rating with a credit spread of 2.75% and an effective spread duration of 6, and the second bond has a BB rating with a credit spread of 3.50% and an effective spread duration of five years.
What is the expected excess spread of the BBB rated bond for an instantaneous 50 bp decline in yields if the bond’s LGD is 40% and the POD is 0.75%?
A 1.95%
B 2.45%
C 2.70
The answer is C. The expected excess spread is equal to the change in spread multiplied by effective spread duration (–(EffSpreadDur × ΔSpread)) less the product of LGD and POD, which we can solve to get 2.70% (=(–6 × 0.50%) – (0.75% × 40%))
What I don’t understand is - based on this answer, it seems that excess spread return just means (–(EffSpreadDur × ΔSpread)) less the product of LGD and POD which means that excess return and excess spread return are not the same thing or are they? and if they are, why are they omitting the initial spread? To me, it doesn’t seem like an instantaneous decline in the yield is the same as Holding Period =0
I think in the textbook excess spread and return are being used interchangeably. The 2 formulas for this are 9 (excess return) & 10 (expected excess return) and expected just means that there is a possibility for default, therefore the POD x LGD are relevant to our expectations and used in the calculation.
To your last point, it does seem that when they mention instantaneous that HP = 0, saying we won’t receive the credit spread over time (2.75 x 0), we receive the change in spread times the duration, and we would expect to lose POD x LGD over time. Pending S2Kmag for confirmation and to drag the credit reading.
is incorrect. However, when they use it in Example 12, they change it to the correct formula (but don’t tell you explicitly that that’s what they’re doing). The correct formula is:
but in the question and answer originally asked, the instantaneous (t = 0) includes POD x LGD which makes no sense if this should multiply by time? if t = 0 both should fully cancel to -dur x delta spread?
CFA historian and exam prep legend S2K, has this sort of thing happened in the past when curriculum has changed? I’m lost on how I should allocate my time in FI, I like the credit reading conceptually but if there’s small chance this ends up on the exam I’d rather visit neglected ethics with my time…
There was one occasion I recall – I don’t remember exactly when, alas – when there were so many errors that CFA Institute announced that that section would not be tested.
I assume EOC 17 is incorrect as well because the spreads rise by 10% instantaneously as well? It’s similar to EOC 12. If instantaneous, time should be 0.
The problem with questions 15 – 17 is that they don’t tell you the holding period. Question 17 on its face sounds as though the holding period is essentially zero: buy the bond, watch the spread widen, panic, and sell it immediately. However, based on the answer, they’re treating it as if the holding period were one year.
Question 12 isn’t any better. They’re treating the holding period as zero for the Spread_0 term, but as one year for the POD \times LGD term.
This section is so confusing - thanks for the clarifications again. Would you please be so kind to explain the concept of Duration Times Spread concept as well? I don’t understand whether we have to multiply DST with spread or percentage point change in spread. thANKs a lot
For low-rated bonds, spread changes tend to be (roughly) proportional to the size of the spread. So a good way to rank the spread risk of such bonds is duration times spread.
In the question, they say " for an instantaneous 50 bp decline in yields", how are we sure that this 50bp decline in yields is due to the spread?? Can’t it be due to yield curve?
