Text:
Trade 1: Sell a 3-year maturity AAA corporate bond and buy a 30-year maturity AAA bond of the same issuer based on the expectation that credit spreads will tighten uniformly by 10 bps across the credit curve.
Question:
Discuss the most significant risk of Trade 1 assuming that the expectation about credit spread is correct.
Solution:
The most significant risk associated with Trade 1 is that while spreads are tightening, long-term interest rates could increase (the yield curve could shift upwards). Thus, the price increase from spread tightening could be offset by the price decrease from the yield curve shift. This yield curve effect is magnified because the 30-year bond has a longer duration than the 3-year bond.
My Question:
@Alta12 @RaviVooda
Why is it that when spreads are tightening the long term interest rates could increase?
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