Petit develops investment recommendations for a currency- hedged portfolio of US and European corporate bonds. She expects US interest rates to decline relative to European interest rates. Furthermore, the spread curve for US corporate bonds indicates that the average spread of five- year BB bonds exceeds the average spread of two- year BB bonds by +90 bps. Petit expects the difference between average credit spreads for these two sectors to narrow to +50 bps.
Answer:
OVERWEIGHT the US bonds
UNDERWEIGHT the two years (which have a lower spread), versus the 5y (with a higher spread).
Could someone please explain why?
I understand why you would like to overweight US bonds (you want to be where the lower yields are, so prices of your bonds/bond value is going up).
UNDERWEIGHT the lower spread: OK, so for two bonds of the same rating (and same risk), why would you want the higher spread? Wouldn´t that drive your prices lower, so it is a contradiction to the overweighting reason above?
Many thanks!!
Overweighting the 5 year will deliver superior returns assuming the spreads narrow. Narrowing of spreads means yiepds on 5 year bonds falling in this context and this will help generate better returns.
I think the OP missed a few pointers:
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The USD/EUR pair is hedged which means there is no relative advantage on the FX part that Petit may reap advantage of.
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If the above is true , my choice boils down to focusing on the asset return( here the BB rated Corp. bond) on the yield curve. Clearly no info. given on the behaviour of the Euro Bonds but for the fact that the borrowing rate ( interest rate that is) is lower in the US
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Now that my choice is narrowed, I would only like to focus on the relative spreads on the BB rated curve across the maturity ( assuming 2 yr. 5 yr. Pair offers the best spread margin)
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Additionally it is music to my ears that the expected margin will narrow by 50 bps- clearly indicating an addl. yield of 40 bps over the horizon.
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Underweighting lower yield 2 yr. BB security is equivalent to borrowing @ 2 yr. security ( and thus leveraging) to fund the purchase of the higher yiedling 5 yr. security.
If expectations are correct Petit would AT LEAST reap a 40bps over the horizon. Rest of the things should be self explanatory. The addl. inference to be drawn or to be tacitly understood is the fact that we are exlcusively talking about BB rated bonds and that there is NO possibility of rating migration ( upgrade or downgrade) in either the 2 yr. or the 5 yr. Security.
There is a name to it- Carry Trade in domestic currency. But you might wanna check it out for yourself.
You buy bonds when spreads are high, because bond prices are low. However, higher spreads mean higher associated risk with repay, so depends on the investor risk profile (ability and willingness to take risk).
If spreads are going to narrow, it means interest rates will fall, increasing the value of your bond. As you have bought bonds cheap, you will find a capital appreciation as @HerbsDelite comments it his 4th bullet.
If you are a investor ready to increase bond exposure, you overweight the bonds with higher spreads over the bonds with lower spreads.