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

Inventory is sometimes thought of as a necessary evil, Inventory is sometim...

Inventory is sometimes thought of as a necessary evil.  Explain. Inventory ties up funds and these funds aren't earning an unambiguous return.  Some inventory is habitually nec

Define working capital, Q. Define Working Capital. Ans. Introduction: - ...

Q. Define Working Capital. Ans. Introduction: - Working capital plays the similar role in the business as the role of heart in the human body. Just like heart gets blood as well

Leverage, what is the meaning of market feasibility? What are its different...

what is the meaning of market feasibility? What are its different types with their degree?

Options markets, Options Markets: Man has always been innovative and in...

Options Markets: Man has always been innovative and ingenuous. His determination to improvise and overcome the limitations of various processes has resulted in phenomenal and e

Functions of financial manager, Functions of Financial Manager: - The finan...

Functions of Financial Manager: - The financial manager is a associate of top management. He is intimately associated with the formulation of financial policies as well as financia

Calculating investment statistics and graphing output, Step 1) Opportunity ...

Step 1) Opportunity Set Graph:Combine 2 of your stocks (Ignore the other 2 stocksfor this step only).  Construct an investment opportunity set (the curved set) between the two risk

What are the government securities - debt securities, What are the Governm...

What are the Government Securities Government is one of the biggest borrowers from capital and money market. We have already taken a look at money market securities offered by

Features of government securities, Features of government securities: ...

Features of government securities: Issuers The government securities are issued by the central government, state governments, and semi-government authorities like municipa

Coupon interest payment, An investor receives periodic interest...

An investor receives periodic interest payments at specified intervals till the date of holding or maturity. However, the holder of zero coupon

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