Question

One common goal among fixed-income portfolio managers is to earn high incremental returns on corporate bonds versus government bonds of comparable durations. The approach of some corporate-bond portfolio managers is to find and purchase those corporate bonds having the largest initial spreads over comparable-duration government bonds. John Ames, HFS’s fixed-income manager, believes that a more rigorous approach is required if incremental returns are to be maximized. The following table presents data relating to one set of corporate/government spread relationships (in basis points, bp) present in the market at a given date:

CURRENT AND EXPECTED SPREADS AND DURATIONS

OF HIGH-GRADE CORPORATE BONDS (ONE-YEAR HORIZON)

Bond Ratings	Initial spread over governments	Expected horizon spread	Initial duration	Expected duration one year from now
Aaa	31 bp	31 bp	4 years	3.1 Years
Aa	40	50	4 years	3.1 Years

a. Recommend purchase of either Aaa or Aa bonds for a one-year investment horizon given a goal of maximizing incremental returns.

b. Ames chooses not to rely solely on initial spread relationships. His analytical framework considers a full range of other key variables likely to impact realized incremental returns, including call provisions and potential changes in interest rates. Describe other variables that Ames should include in his analysis, and explain how each of these could cause realized incremental returns to differ from those indicated by initial spread relationships.

Short answer

a. Aaa bonds

b. Maturity effect, Changes in issue-specific credit quality:

Step-by-step solution

Comparison of Aaa or Aa bonds for purchase

While the Aa bond initially has the higher YTM (yield spread of 40 b.p. versus 31 b.p.), a widening spread relative to Treasuries will reduce the rate of return.

On the other hand, the Aaa spread is expected to be stable.

Let’s find out the comparative returns:

Formula:

Incremental return over Treasuries: Incremental yield spread - (Change in spread x duration)

Aaa bond: 31 bp - (0 x 3.1) = 31 bp

Aa bond: 40 bp - (10 bp x 3.1) = 9 bp

Since the incremental return of the Aaa bond, it is an advisable choice.

Explanation of other variables and their inclusion in the analysis

(i) Changes in issue-specific credit quality: This implies that the change in the credit quality of the bond changes treasuries’ relative spreads too.

(ii) Maturity effect: As bonds near maturity, the effect of credit quality on spreads can also change thereby differently affecting bonds of different initial credit quality.