Question

Read the news article below and answer the question in the space provided. =============================================================== Now credit analysis is part of stock analysis In the coronavirus pandemic, stock analysts have a new job: credit analysis.

As the global economy grinds to a standstill amid mandatory shutdowns, the survival of many businesses is suddenly in doubt, especially those in vulnerable sectors such as airlines, hotels and restaurants. Instead of asking how fast a company can grow, ever-optimistic equity analysts now have to answer a grimmer question: how long can it last if its revenue vanishes? This focus on cold, hard cash means they have to do work that is more familiar to credit analysts: analyzing available liquidity, looking at debt covenants and repayment schedules and checking the extent to which assets are unencumbered. While the current economic freeze is unprecedented, making it hard to prepare for, investors overlooked credit health in the bull market. They were focused on growth -- never mind whether companies were able to make money -- and often pie-in-the-sky projections of potential market size. Now that balance sheets have taken center stage, traditional metrics like net debt to earnings before interest, taxes, depreciation and amortization or even tangible book value are back in vogue. Even for companies whose businesses aren't immediately at risk, refinancing existing debts could pose big problems. The junk-bond market has stalled in recent weeks, so investors need to understand what alternative financing channels are available to companies: credit lines from banks or assets that could be used to secure loans. Even for those that can still borrow, the surging costs will hurt their profits down the road. Average yield on dollar-denominated, junk-rated corporate bonds stands at 12%, up from below 6% just a month ago, according to data from S&P Dow Jones Indices. With everyone in cash-preservation mode, companies that used to pay generous dividends are starting to cut back. Delta Air Lines, Marriott International, Macy's and Ford Motor have all suspended their payouts in recent days, and more will likely follow. Analysts better acquainted with income statements need to pay closer attention to companies' balance sheets right now. ===========================================================

Your friend owns some U.S. Treasury zero-coupon bonds with 5 years to maturity. He holds the securities for duration matching to his liabilities. In the past month, the treasury bond yield has dropped from 3% to 1%. While from the above news article, the yield of corporate zero-coupon bonds with the same maturity has increased from 6% to 12%. Observing the changes, your friend wants to sell the (low-yield) treasury bonds currently owned and use the proceeds to buy (high-yield) corporate bonds of the same maturity. His transaction is motivated by the following two statements.

Statement 1. Given that the two zero-coupon bonds (treasury bonds and corporate bonds) have a maturity of 5 years, his interest rate risk exposure on bond investments will remain unchanged after the transaction.

Statement 2. The yield spread between two bonds provides an arbitrage opportunity because the transaction will bring higher returns while the interest rate risk remains unchanged. Required: Do you agree with your friend? Comment on his two statements.

Answer 1

Statement 1 - As per this statement both securities have unchanged interest rate risk and still if he sold his Treasury bond which will pay interest rate @ 3% and then buy corporate bond which will pay interest rate @ 6%. So the friend still earn interest 3% more on corporate bond if interest rate risk exposure on bond investments will remain unchanged after the transaction.

Statement 2 – Yes, there is huge difference between treasury and corporate bond interest rate 1% and 12% respectively. So, these is right opportunity to the friend due to yield spread between these both bonds.