Yield spread strategies, Financial Management

Assignment Help:

Bond market can be classified into various segments based on the nature of characteristics such as type of issuer (central bank, corporate etc.), credit risk (risk-free, AAA etc.), coupon level (zero coupon, high coupon or low coupon) and maturity (short-, medium-, or long-term) etc.

Any difference in the characteristics should cause a difference in the yield i.e., yield spread. When we consider the differences in maturity, then it will give rise to yield curve strategies.

Yield spread or spread strategies depend on the positioning of portfolio components to make gains from movements in yield spreads between different segments of the bond market. The major technique involved is bond swapping. Bond swapping implies exchanging an overvalued bond in the portfolio for another bond that the portfolio manager considers undervalued by the market.  Both, undervaluation and overvaluation are measured in terms of spread. The spread is too wide in the case of undervaluation and it is too narrow in case of overvaluation. When the yield spread between the two bonds results in realignment, then the manager will capitalize the difference by reversing the bond swap.

The yield of the bond that is sold increases and the yield on the purchased bond decreases.

Yield spreads can be established from different sources. One of the significant yield spreads is credit spread. It implies bonds of lower quality trade at a spread with regard to higher quality bonds. This spread between low and high quality bonds will increase when the economy sets into recession and it will become narrow during boom phases, i.e., lower quality issuers will experience more difficulties in servicing their debt when the economic activity in general is low because subsequently their income from operations will also decrease.  With this fact known, the portfolio manager will swap low quality bonds for high quality bonds when the economic activity is approaching its peak (flight to quality) and when the recession sets in the portfolio manager does the opposite.

Another significant source of spread to be noted is call provision. However, the probability that the issuer will exercise the call option is closely related to the level of interest rates and their volatility. The probability of exercising call option will decrease with the level of interest rates and will increase with the volatility of the underlying asset interest rate. In this way, the portfolio manager, on expecting a decrease in the level of interest rates, can swap callable for non-callable bonds as the spread is likely to increase.


Related Discussions:- Yield spread strategies

Agency relationships, conflicts between shareholders and government in agen...

conflicts between shareholders and government in agency relationship

Stakeholders, identify five stakeholder groups and breifly explain their fi...

identify five stakeholder groups and breifly explain their financil and other objectives

Forms of liquidity, Forms of Liquidity: Definition: Liquidity defines ...

Forms of Liquidity: Definition: Liquidity defines to how quickly and cheaply an asset will be converted into cash. Money (in the form of cash) is the most liquid asset. Assets

Condition market to book value ratios be misleading, Under what circumstanc...

Under what circumstances would market to book value ratios be misleading?  Explain. The Market to Book ratio is helpful, but it is just only a rough approximation of how liquid

Explain exchange rate affect the return from foreign market, Explain how ex...

Explain how exchange rate fluctuations influence the return from a foreign market measured in dollar terms. Discuss the empirical proof on the effect of exchange rate doubt on the

Financing costs incorporated into capital budgeting analysis, How are finan...

How are financing costs generally incorporated into the capital budgeting analysis process? Financing costs are generally captured in the discount or hurdle rate while doing NPV

Explain career counselling process, Q. Explain career counselling process? ...

Q. Explain career counselling process? The career counselling process should contain the following elements: a. The employee's should goals, aspirations and expectations wit

Constructing index numbers - aggregates method, Aggregates Method Unde...

Aggregates Method Under the aggregates method of constructing an index number, we could have unweighted aggregates index and the weighted aggregates index. Unweighted Aggr

Residual method to find cyclical variation, Residual Method We know th...

Residual Method We know that a time series consisting of annual data for longer periods is depicted by trend lines. This facilitates us to isolate the component of secular tre

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd