Question

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. 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.

I would disagree with the statement 1 because the investor currently has Treasury Zero coupon whose yield dropped from 3% to 1% which will increase the value of Zero coupon bond the investor holding, but if he enters into a transaction of buying corporate zero coupon, by selling treasury zero coupon, whose yield just increased from 6% to 12% the value of zero corporate bond yield will decrease because interest will have inverse effect on the value of the bond. Thus Investor will be exposed to interest rate risk if transaction takes place.

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.
I would agree with this statement because Treasury zero coupon bond is giving a yield of 1% while corporate zero coupon is giving a yield of 12% which means the investor can make a risk free profit by selling treasury zero coupon and buying corporate zero coupon bond