Question

Initially Baa-rated bonds yield 7%, while Aa-rated bonds yield 4%.

Now suppose that due to an increase in market uncertainty, investors become more willing to buy safer bonds and sell riskier bonds. How might this demand shift affect the prices and YTM of the above bonds? Why?

If the yield of safer of the above bonds increases by 1% and yield of riskier bonds decreases  by 1%. What are the new yields?

Is such change consistent with the story above? Why?

What would happen to the confidence index? Change from _______________ to _______________

Is such confidence index change considered bullish or bearish?

Answer 1

A highly-rated bond (let's say AA rated here) has a lower risk than poorly rated bonds (in this case BAA). For investors to invest in a BAA rated bonds, as compared to an AAA-rated bond, it is important for BAA rated bonds to provide a sufficiently higher rate of return in order to compensate for the excess risk taken. In short, the bond yield must be in line with the risk-return relationship.

Due to market uncertainty, investors are more willing to buy safer bonds. Hence, the demand for safer bonds goes up. As demand goes higher, the bond prices go high, which in turn results in lower yields on these bonds. Hence, the difference between the yields of a risky and safer bond goes higher. Conversely, as investors sell riskier bonds, the market price of such bonds decreases, hence resulting in higher yields on these riskier bonds.

In this case, an AAA-rated bond would yield 5% and a BAA rated bond would yield 6%. This is an aberration from the situation discussed above since the yields of safer bonds have gone up and vice-versa, or the prices of highly rated bonds have gone down and the prices of relatively poorly rated bonds have gone up. In this case, the confidence index increases, ie. more consumers are now willing to take the additional risk for higher returns since they believe that markets are undervalued and hence rush to buy relatively poorly rated bonds in expectation for a higher return.

The confidence index is the ratio of the yield of high-grade corporate bonds to the yields of lower-graded bonds. Yields on a highly rated bond is always lower than the yields on the lowly rated bonds. Hence this index is always lesser than 1. As the bullish sentiment keeps on increasing, this index move closer and close to 1.In the case discussed above, the confidence index increases resulting in a change of consumer stance from bearish to bullish. Such confidence index change is considered as bullish now more and more investors are willing to buy low-rated speculative bonds in expectation of higher returns.