Module 6: Fixed Income Markets, Instruments, and Strategies…
Questions
Mоdule 6: Fixed Incоme Mаrkets, Instruments, аnd Strаtegies Questiоn 6A (10 points) Yield measures are widely used to evaluate fixed-income securities, but each has important limitations. Compare yield to maturity, yield to call, yield to worst, and total return. Discuss the assumptions underlying each measure and explain why total return is often a more comprehensive measure of bond portfolio performance. Question 2B (12 points) You have recently been promoted to senior portfolio manager for a bond mutual fund. A junior portfolio manager presents the following report during an investment committee meeting. "Our bond portfolio currently has a market value of $250 million and a duration of 6.5 years. This means we should expect the portfolio to mature in approximately 6.5 years. Because the duration is only 6.5, the portfolio is not very sensitive to changes in interest rates. If market interest rates increase by 100 basis points, the portfolio should gain approximately 6.5% in value. Likewise, if interest rates fall by 100 basis points, the portfolio should lose approximately 6.5%. Since we expect interest rates to decline over the next year, I recommend reducing the portfolio duration from 6.5 years to about 3 years because lower-duration portfolios benefit the most when interest rates fall. In addition, since duration completely measures interest-rate risk, we do not need to consider changes in the shape of the yield curve when managing the portfolio." As the senior portfolio manager, prepare a memorandum evaluating this recommendation. In your answer: Identify and explain at least six conceptual errors in the junior manager's discussion. Explain what portfolio duration actually measures. Estimate approximately how much the portfolio's value would change if market interest rates increase by 100 basis points and if they decrease by 100 basis points. Explain how duration should be used in managing a bond portfolio. Question 6C (13.34 points) You have recently joined an asset management firm as a junior fixed-income portfolio manager. After attending your first investment committee meeting, you submit the following recommendation to the Chief Investment Officer. "I recommend that we increase the portfolio's average maturity as much as possible because longer-maturity bonds are always better investments. Since bond prices always return to par at maturity, there is little risk in holding long-term bonds. To increase returns, I also recommend purchasing as many callable bonds as possible because they generally offer higher coupon rates and will appreciate the most when interest rates fall. To reduce portfolio risk, we should avoid Treasury securities because they offer the lowest yields. Instead, we should concentrate the portfolio on below-investment-grade corporate bonds because they offer the highest yields and, therefore, the highest returns. We should also avoid municipal bonds because they pay lower interest rates than corporate bonds. Since we expect interest rates to decline, there is no reason to be concerned about reinvestment risk or liquidity risk. Furthermore, yield to maturity tells us everything we need to know about a bond's expected performance, so there is no need to consider total return or duration when evaluating bonds. Finally, I recommend constructing the portfolio as a bullet portfolio because bullet portfolios always outperform barbell and ladder strategies regardless of changes in the yield curve." As the senior portfolio manager, prepare a memorandum evaluating this recommendation. Identify and explain at least eight conceptual errors or questionable statements. For each point, explain why the statement is incorrect and describe the appropriate fixed-income principle or portfolio management practice.
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