As a bond portfolio manager, you try to read all of the written analysis you can regarding the current conditions of the financial markets. The following is an extract of a bond strategy briefing note issued by an investment bank:
"The recent fire sale puts excessive selling pressure on high-grade corporate bonds. The fear of systemic risk over the banking system and of the increasing default risk in junk bonds provides an unprecedented opportunity under which yield spreads have widened to extremely attractive levels. We recommend that our clients reduce their portfolio weights in U.S. Treasuries and increase their positions in AA- and A-rated bonds with coupon rates between 7-9% as part of its core strategic reallocation."
After reading the analysis and recommendation, you note that the current 30-year U.S.
Treasury bond yield is about 5 percent. Also, you agree that the yield spreads have widened to attractive levels and interest rates will fall further by as much as 100 basis points in the next 12 months.
a. Explain why the investment bank's bond portfolio reallocation recommendation would not work, given your view of the market.
b. How can you modify the recommendation in the briefing note in view of the reservations you expressed in Part a?