Question

An historical analysis of 1yr yield spreads has shown that sovereign yields are typically 65% the size of corporate yields. At present, 1yr sovereigns are offering 4% while 1yr corporates offer 5.5%.   What course of action should you take if you believe spreads will return to normal levels?

Answer 1

Based on historical analysis, the sovereign yield should be 65% x 5.5% = 3.575% or the corporate yield should be 4% / 65% = 6.15%

It means that the current spread (difference between corporate and sovereign yields) have narrow. If it returns to the normal levels, then either the sovereign yield will decline to 3.575% or the corporate yield will rise to 4% or may be both will happen simultaneously.

Hence, you should buy the sovereign bond and/or sell the corporate bond if you believe that the spread would return back to the normal level.