Why does the bond’s return increase?
Is it that when the spread decreases (yield reduce’s) , the price goes up and hence the portfolio value goes up overall and thus the return on this bonds increases ?
I am unable to wrap my head around this statement. I want to understand the logical reasoning behind this.
This makes sense but is there any other reasoning or to explain this differently ?
I think they mean that if you already have the bond and new issuances increase, it will drive the market rate lower, making the bond in your hand worth more than what is being sold in the market thus increasing the value of your bond.
I don’t understand the validation reason though? …
Zanalyst, in your statement did you mean - " it will drive the market rate lower" or the market price lower ?
When there is more supply of a product compared to demand, the price of that product would decrease. How does decrease in interest rate justify. I am sorry if i am completely off line here.
Coming to the validation question you had:
Take this scenario: We are trading in secondary market say on Nokia AA bond and we look for what a similar AA rated bond is issued for in the primary market( new issues ) and decide this as our benchmark and based on that we might as traders ask for a premium or discount in the secondary market. ( thus we have a reference - the primary market)
But if we do not have any data to benchmark against from the primary market, we as traders would be better off quoting a higher rate ( higher spread) to be on the safe side.
Hope this explains…
realize one thing … higher rate = lower price on bonds. So if you really want a higher price - you want a lower spread with relation to treasury or whatever your benchmark is. Validation is about - what is the security (similar one) selling for. If the company has issued bonds before - and is now issuing a second issue - if the secondary bond issue is highly priced - and you possess the original issued bonds - you know that the primary issue is not going to be way off in price. so you got a validation on your issue from the new issue. as regards the price part - a new issue is selling well - but there is no infinite supply of it available- so its price due to it being in limited supply is going to increase. When the price increases - its yield decreases - so the spread shrinks.
cpk=santa of AF!
Thanks CPK. I got your explanation on your first two para’s. Appreciate your response. But regarding Price - i am still confused. Your statement is in line. But this happens(after certain time passes) only when the market is cleared of the increased in supply - the spreads will narrow down & price will increase. But initially when there is influx of extra supply why should the yield contract & price increase ? (or) Am i looking at this completely wrong ? I should view them as one single scenario or two different stages in a single scenario. To support my above statement, if you would look at question 15, pg 85: “The Chicago trust co. plans to buy single A Corporate bonds with intermediate maturities starting this quarter, as the firm swaps out of lower rated, BBB rated paper to take advantage of attractive spreads from an anticipated flood of single A supply… This flooding of single A rated papers, blows out spreads and thus creating buying opportunities” The explanation in the answer given was as follows - “There will be a surge of Single - A rated issues that will come to market, resulting in a widening of spreads and thereby providing an opportunity to purchase single A rated issues relatively cheaply versus BBB issues. It is assumed that once the market is cleared of the increase in supply of Single A rated issuers, the spread will narrow and provide better performance relative to BBB rated issuers.” ( Pg 93 ) PS: the statements in quotes are as per text book not my reasoning.
will talk about it when I read this chapter. above that I quoted was probably wrong. This chapter is wicked in its entire approach to the subject…
Thank you CPK. Will keep this in my mind and we can discuss if something else comes up or some one puts up a better explanation. Q9 and Q15 are the two one’s which kind of set up contradicting views with out my explanation. Watch out folks.
I thought I understood the chapter while reading, but know I’m confused…ahhhhh Maybe they mean new issuance of investment grade bonds happen when the general markets yield spreads are low and bond returns are strong… Not necessarily one causing the other but happening in the same time period?.. Yes,no, maybe?
First part: Bonds are purchased when yields spreads are wide, a poor economic environment - so later the prices increase (spreads narrow) and as a result returns improve. Second Part: New bond issuances signify that either the firm or the economy is poised for good things - so bonds flood the market - yields fall - and prices rise.
thank for mentioning these questions, ganershpl
Thank you CPK for the below statements.