In the corporate bond market, spread curves often differ considerably across issuers . . .
Most fixed income investors understand the relation between the term structure of interest rates and implied forward rates. But some investors overlook the fact that a similar relation holds between the term structure of corporate spreads and forward corporate spreads. Specifically, when the spread curve is steep, the forward spreads imply that spreads will widen over time. By contrast, a flat spread curve gives rise to forwards that imply stability in corporate spreads. Essentially the forward spread can be viewed as a breakeven spread . . .
Sometimes, investors may disagree with the expectations implied by forward rates, and consequently they may want to implement trading strategies to profit from reshapings of the spread curve.
- What is meant by “spread curves” and in what ways do they differ across issuers?
- Consider the relationship between the term structure of interest rates and implied forward rates (or simply forward rates). What is a “forward spread” that Mr. Crabbe refers to and why can it be viewed as a breakeven spread?
- How can implied forward spreads be used in relative-value analysis?
A. Spread curve = spread over treasury. = YTM of the bond - YTM of treasury. (if you take these values across different maturity and plot a graph, that will be considered spread curve).
Why could it be different across issuers? simply because risk premium across different issuers is different.
for a small cap highly leveraged company, spread curve may be steep.
for a large cap yet not highly leveraged company, spread curve may be relatively flat.
I do somehow understand B and C but not able to put it in words… I’ll go through material again and give it a try…
Does A make sense? I’d like if someone can validate.
forward spread is like how you used two spot rates to calculate a forward rate
(1+s2)^2 = (1+s1) * (1+1f1)
1f1 = 1 year forward rate 1 year from now
similarly if you do the same operation on two spread YTMs (1 current, and 1 1 year from now) and get the 1 year forward spread 1 year from now using those two - you get a forward spread.
This spread makes you indifferent between the YTM now and YTM 1 year from now (2 year YTM).
hence it is a breakeven spread.
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Part 3) not sure about this part. I believe a higher forward spread would imply a cheaper bond.
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the other question I am very unclear about - this if I am not mistaken is a straight lift off EOC question. so why is it you meticulously type out the question - when the answer is so available to you
Thanks for answering. It is a EOC q. I do not understand the answer they have given. Thought you guys could clarify it. I’m not too sure about B and C. Investor would be indifferent between two YTMs but where does the spread analaysis come in here?
Forward rate…Nightmare in L1 and L2.
Remember this: forward spread is one that will make an investor indifferent between two alternatives.
It’s in relative value FI 1. I will look it up later if you want.
Solution is here. I’m not fully understand it either…
A. Spread curves show the relationship between spreads and maturity. They differ by issuer or sector in terms of the amount of the spread and the slope of the spread curve.
B. Forward rates are derived from spot rates using arbitrage arguments. A forward spread, or an implied forward spread, can be derived in the same way. Also, forward rates were explained as basically hedgeable or breakeven rates—rates that will make an investor indifferent between two alternatives. For example, for default-free instruments a 2-year forward rate 3 years from now is a rate that will make an investor indifferent between investing in a 5-year zero-coupon default-free instrument or investing in a 3-year zero-coupon default-free instrument and reinvesting the proceeds for two more years after the 3-year instrument matures. A forward spread can be interpreted in the same way. For example, a 2-year forward spread 3 years from now is the credit spread that will make an investor indifferent to investing in a 5-year zero-coupon instrument of an issuer or investing in a 3-year zero-coupon instrument of the same issuer and reinvesting the proceeds from the maturing instrument in a 2-year zero-coupon instrument of the same issuer. C. The forward spread is a breakeven spread because it is the spread that would make the investor indifferent between two alternative investments with different maturities over a given investment horizon. Because a forward spread is one that will make an investor indifferent between two alternatives, a manager must compare his or her expectations relative to the forward spread. Relative-value analysis involves making this comparison between expected spread and what is built into market prices (i.e., forward spread).