LOS f: Describe a credit spread and discuss the suggested relation between credit spreads and the well-being of the economy.

Q1. Which of the following is the reason why credit spreads between high quality bonds and low quality bonds widen during poor economic conditions?

A)   default risk.

B)   indenture provisions.

C)   interest risk.

Q2. If a U.S. investor is forecasting that the yield spread between U.S. Treasury bonds and U.S. corporate bonds is going to widen, then which of the following is most likely to be TRUE?

A)   The economy is going to expand.

B)   The U.S. dollar will weaken.

C)   The economy is going to contract.

Q3. If investors expect greater uncertainty in the bond markets, you should see yield spreads between AAA and B rates bonds:

A)   slope downward.

B)   widen.

C)   narrow.

Q4. Which of the following is the most appropriate strategy for a fixed income portfolio manager under the anticipation of an economic expansion?

A)   Sell corporate bonds and purchase treasury bonds.

B)   Enter a pay-fixed, receive-floating rate swap.

C)   Purchase corporate bonds and sell treasury bonds.

LOS f: Describe a credit spread and discuss the suggested relation between credit spreads and the well-being of the economy.fficeffice" />

Q1. Which of the following is the reason why credit spreads between high quality bonds and low quality bonds widen during poor economic conditions?

A)   default risk.

B)   indenture provisions.

C)   interest risk.

Correct answer is A)        

During poor economic conditions the probability of default increases and thus credit spreads widen.

Q2. If a ffice:smarttags" />U.S. investor is forecasting that the yield spread between U.S. Treasury bonds and U.S. corporate bonds is going to widen, then which of the following is most likely to be TRUE?

A)   The economy is going to expand.

B)   The U.S. dollar will weaken.

C)   The economy is going to contract.

Correct answer is C)

If economic conditions are expected to get worse, then the probability that corporations may default increases and causes credit spreads to widen.

Q3. If investors expect greater uncertainty in the bond markets, you should see yield spreads between AAA and B rates bonds:

A)   slope downward.

B)   widen.

C)   narrow.

Correct answer is B)

With greater uncertainty, investors require a higher return for taking on more risk. Therefore credit spreads will widen.

Q4. Which of the following is the most appropriate strategy for a fixed income portfolio manager under the anticipation of an economic expansion?

A)   Sell corporate bonds and purchase treasury bonds.

B)   Enter a pay-fixed, receive-floating rate swap.

C)   Purchase corporate bonds and sell treasury bonds.

Correct answer is C)

During periods of economic expansion corporate yield spreads generally narrow, reflecting corporate bonds decreased credit risk. If yield spreads narrow, the price of corporate bonds increases relative to the price of treasuries.

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