Yield spread widens = decrease spread duration?

CFA Level III Fixed Income
#1

Guys,

Why do we decrease spread duration when the yield spread between two bonds or sectors widens?

#2

Change in Price = -1 * Change in Rate * Duration

Rate increases means Price falls - to reduce the amount by which price changes - you need to reduce the duration (or in this case spread duration).

#3

But what is the relation to spread yield?

#4

Yield Spread = Yield of Bond - Yield of Treasury of same maturity.

So if Yield Spread of the Bond is increasing - Yield of the Bond is BECOMING BIGGER.

So Price of that bond is falling.

So you need to reduce its duration.

#5

Spread duration = modified (or effective) duration

If spreads widen and the Treasury YTM doesn’t change, the modified (or effective) duration doesn’t change, so there should be no change in the spread duration.

Did you read somewhere that the spread duration should change?

#6

I think we’re talking about different things guys.

Find below the full quote from the book. I am referring to the section on relative value analysis for bonds.

“Another strategy assumes the delta in interest rates of two bond sectors will not change by the same amount. Making the assumption that portfolio duration is kept the same, the spread change will determine which bond will have superior relative performance”.

Rules:

If yield spread is expected to narrow, increase spread duration

If yield spread is expected to widen, decrease spread duration

Thanks guys

#7

Where, exactly, is that quote?

#8

What?? You threw me a huge curveball here s2000. Sounds like cpk has been too because you’re saying hes wrong. I would have said same thing as cpk. How are we wrong??

#9

Andrevc’s quote is from Schweser I believe. I’ve seen it in there. Makes total sense to me. If you expect credit spreads to widen (narrow) then decrease (increase) spread duration.

#10

S2000 is right that Spread Duration does not change automatically, but the portfolio manager should make it change based on the yield movements.(buy treasury futures when Spreads narrow [Increase duration], sell treasury futures when spreads widen[decrease duration]).

#11

Ohhhh ok well ya Id hope that’s obvious that an action needs to be taken.

#12

Wording is so important on this forum, I’ve learned.

#13

Yes, it’s on Schweser - p. 249

Googs, can you explain why it makes perfect sense to you? Perhaps with an example?

#14

when spreads WIDEN - assume for a moment that the Treasury Yield is fixed. This means the Yield on your bond is GETTING BIGGER.

If Yield is getting bigger - you are going to get a lower price. Yield getting bigger does not do anything to the Duration of the Bond itself - but your Spread Duration # - is bigger than what it was before.

So now you need to “reduce” your duration on the bond - so that your portfolio impact due to the price dropping is reduced.

And you would do that (reduce the duration of your portfolio) by Selling Treasury Futures.

#15

Okay, I get your example cpk123. But two follow-up questions:

  1. Why are we assuming that the Treasury yield is fixed? The book says “when spreads widen”. So, in theory, we could have the yield on the bond dropping, with treasuries dropping even more - i.e. spreads would widen and yield on the bond would be lower (it wouldn’t make sense anymore to decrease duration)

  2. Why are we always assuming spreads vs. treasuries? In the book quote I thought they were referring to two non-treasuries bonds. Would our conclusions change somehow?

Thanks!

#16

Spread is always with respect to Treasury securities of the same maturity.

I quote from the book

A measure that describes how a non- Treasury security’s price will change as a result of the widening or narrowing of the spread is spread duration. And** The risk that a bond’s price will change as a result of spread changes (e.g., between corporates and Treasuries) is known as spread risk.** (This proves Spread = Spread Change between Corporate and Treasury).

And you need a benchmark for the direction of the move. Usually for a treasury bond’s yield to change - you need higher powers to step in (e.g. the Fed to change things in a big way). So keep the treasury rate constant - and if spread widens it means the Corporate bond’s yield GOES UP!

#17

From the reading on Relative Valuation

During recessions, the escalation of default risk widens spreads (which are risk premiums over underlying, presumably default-free, government securities [or swaps]) and reduces credit returns relative to Treasuries.

#18

+1 to what ^ said.

#19

Andrevc you are pulling a classic me moment and over thinking a simple pre level I concept. You need to try and get over it. I know it’s tough, trust me. But you’ll get demolished if try and think outside of anything in the text.

#20

Yeah… The KISS rule - Keep It Simple Stupid - applies even to the CFA, or perhaps especially to the CFA… I find this to be very true in some of S2000’s best explanations on this forum, he does a great job of dumbing things down. Perhaps by the nature of the personalities enrolled in this self-loathing exercise, uhm… program, we like to over analyze things to death. I’d like to think it’s mainly because most of us are curious individuals by default…