Higher spread - a positive for Excess Return Model?

[firefirehelphelp]

Hi everyone,

Can I just check if there is an issue with the statement highlighted below? Doesn’t a higher spread mean Δs is higher and so XR would be less? I can’t see how this is a positive.

Thank you.

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Excess return model:

XR = (s × t) – (Δs × SD) – (t × p × L).

Assuming the analyst does not expect spread to change, this issue becomes comparing the incremental spread earned versus estimated default losses. This is complicated because the factors are interrelated; bonds with higher expected default losses (a negative) usually have higher spread (a positive).

[firefirehelphelp]

Bump anyone? I came back to this after 2 months and still can’t figure it out. Thank you.

[na_27]

Here is my understanding of this:

If you don’t already own the bond, and the spreads are higher, it is a positive because the price of the bond is likely lower, making it an attractive investment. Now if the spreads are expected to narrow, prices will increase, you will make a gain. Even if they they are not expected to change, the bond is still an attractive investment given its low price.

[firefirehelphelp]

@na\_27

Here is my understanding of this:

If you don’t already own the bond, and the spreads are higher, it is a positive because the price of the bond is likely lower, making it an attractive investment. Now if the spreads are expected to narrow, prices will increase, you will make a gain. Even if they they are not expected to change, the bond is still an attractive investment given its low price.

Hey na_27, thanks a lot for your help. Yes it makes sense. I guess instead of looking at that formula, I should have been thinking of it in terms of %Δ relative value = –DS Δs so as spreads are higher the bond value would be lowered.