Final answer:
The correct answer is option b. If an investor anticipates the yield spread between U.S. Treasury bonds and Baa rated corporate bonds has peaked and will narrow, the suggested position would be to short Treasuries and go long on Baa corporate bonds.
Step-by-step explanation:
The question asks about the investment strategy one should consider if they anticipate that the yield spread between a U.S. Treasury bond and a Baa rated corporate bond has peaked. When yield spreads are high during periods such as a recession, corporate bond yields are significantly higher compared to Treasury bonds to compensate for the higher default risk.
If the spread is expected to decrease after reaching its peak, it suggests that investors expect that the risks associated with corporate bonds are diminishing or that the economy is improving, which would generally lead to a narrowing of the yield spread.
Based on this hypothesis, the most suitable position to take would be option (b) short Treasuries, long Baa. This means selling Treasury bonds expecting their prices to decrease (yield increases) and buying Baa corporate bonds expecting their yields to decrease and prices to rise as the yield spread narrows.
To elaborate, when you are long on an asset, you own it with the expectation that its price will rise over time. Conversely, when you short an asset, you are betting that its price will decline. By going long on Baa bonds, an investor capitalizes on the expected spread compression through price appreciation as yields come down.
By shorting Treasuries, they may benefit from the rebalancing of the market's risk appetite, where money flows out of safe-haven assets (e.g., Treasuries), potentially causing their prices to fall and yields to rise relatively.