Case Problem 10.1 Max and Veronica Develop a Bond Investment Program
Max and Veronica Shuman, along with their teenage sons, Terry and Thomas, live in Portland, Oregon. Max is a sales rep for a major medical firm, and Veronica is a personnel officer at a local bank. Together they earn an annual income of around $100,000. Max has just learned that his recently departed rich uncle has named him in his will to the tune of some $250,000 after taxes. Needless to say, the family is elated. Max intends to spend $50,000 of his inheritance on a number of long-overdue family items (like some badly needed remodeling of their kitchen and family room, the down payment on a new Porsche Boxster, and braces to correct Tom’s overbite). Max wants to invest the remaining $200,000 in various types of fixed-income securities.
Max and Veronica have no unusual income requirements or health problems. Their only investment objectives are that they want to achieve some capital appreciation, and they want to keep their funds fully invested for at least 20 years. They would rather not have to rely on their investments as a source of current income but want to maintain some liquidity in their portfolio just in case.
1. Describe the type of bond investment program you think the Shuman family should follow. In answering this question, give appropriate consideration to both return and risk factors.
2. List several types of bonds that you would recommend for their portfolio and briefly indicate why you would recommend each.
3. Using a recent issue of the Wall Street Journal, Barron’s, or an online source, construct a $200,000 bond portfolio for the Shuman family. Use real securities and select any bonds (or notes) you like, given the following ground rules:
· The portfolio must include at least one Treasury, one agency, and one corporate bond; also, in total, the portfolio must hold at least five but no more than eight bonds or notes.
· No more than 5% of the portfolio can be in short-term U.S. Treasury bills (but note that if you hold a T-bill, that limits your selections to just seven other notes/bonds).
· Ignore all transaction costs (i.e., invest the full $200,000) and assume all securities have par values of $1,000 (although they can be trading in the market at something other than par).
· Use the latest available quotes to determine how many bonds/notes/bills you can buy.
4. Prepare a schedule listing all the securities in your recommended portfolio. Use a form like the one shown below and include the information it calls for on each security in the portfolio.
5. In one brief paragraph, note the key investment attributes of your recommended portfolio and the investment objectives you hope to achieve with it.
Latest Quoted Price
Number of Bonds Purchased
Annual Coupon Income
Example: U.S Treas – 18.5% – 18
Case Problem 10.2 The Case of the Missing Bond Ratings
It’s probably safe to say that there’s nothing more important in determining a bond’s rating than the underlying financial condition and operating results of the company issuing the bond. Just as financial ratios can be used in the analysis of common stocks, they can also be used in the analysis of bonds—a process we refer to as credit analysis. In credit analysis, attention is directed toward the basic liquidity and profitability of the firm, the extent to which the firm employs debt, and the ability of the firm to service its debt.
A table of Financial Ratios (all ratios are real and pertain to real companies)
3.Net Profit Margin
4.Return on total capital
5.Long- term debt to total capital
6.Owener’s equity ratio
7.Pretax interest coverage
8.Cash flow to total debt
1. Current ratio = current assets / current liabilities
2. Quick ratio = (current assets -inventory) / current liabilities
3. Net profit margin = net profit / sales
4. Return on total capital – pretax income / (equity + long-term debt)
5. Long-term debt to total capital = long- term debt/ ( long- term debt + equity)
6. Owner’s equity ratio = stockholder’s equity / total assets
7. Pretax interest coverage = earnings before interest and taxes /interest expense
8. Cash flow to debt debt = (net profit + depreciation) / total liabilities
The financial ratios shown in the preceding table are often helpful in carrying out such analysis. The first two ratios measure the liquidity of the firm; the next two, its profitability; the following two, the debt load; and the final two, the ability of the firm to service its debt load. (For ratio 5, the lower the ratio, the better. For all the others, the higher the ratio, the better.) The table lists each of these ratios for six companies.
1. Three of these companies have bonds that carry investment-grade ratings. The other three companies carry junk-bond ratings. Judging by the information in the table, which three companies have the investment-grade bonds and which three have the junk bonds? Briefly explain your selections.
2. One of these six companies is an AAA-rated firm and one is B-rated. Identify those companies. Briefly explain your selections.
3. Of the remaining four companies, one carries an AA rating, one carries an A rating, and two have BB ratings. Which companies are they?
Case Problem 11.1 The Bond Investment Decisions of Dave and Marlene Carter
Dave and Marlene Carter live in the Boston area, where Dave has a successful orthodontics practice. Dave and Marlene have built up a sizable investment portfolio and have always had a major portion of their investments in fixed-income securities. They adhere to a fairly aggressive investment posture and actively go after both attractive current income and substantial capital gains. Assume that it is now 2016 and Marlene is currently evaluating two investment decisions: one involves an addition to their portfolio, the other a revision to it.
The Carters’ first investment decision involves a short-term trading opportunity. In particular, Marlene has a chance to buy a 7.5%, 25-year bond that is currently priced at $852 to yield 9%; she feels that in two years the promised yield of the issue should drop to 8%.
The second is a bond swap. The Carters hold some Beta Corporation 7%, 2029 bonds that are currently priced at $785. They want to improve both current income and yield to maturity and are considering one of three issues as a possible swap candidate: (a) Dental Floss, Inc., 7.5%, 2041, currently priced at $780; (b) Root Canal Products of America, 6.5%, 2029, selling at $885; and (c) Kansas City Dental Insurance, 8%, 2030, priced at $950. All of the swap candidates are of comparable quality and have comparable issue characteristics.
1. Regarding the short-term trading opportunity:
· What basic trading principle is involved in this situation?
· If Marlene’s expectations are correct, what will the price of this bond be in two years?
· What is the expected return on this investment?
· Should this investment be made? Why?
2. Regarding the bond swap opportunity:
· Compute the current yield and the promised yield (use semiannual compounding) for the bond the Carters currently hold and for each of the three swap candidates.
· Do any of the swap candidates provide better current income and/or current yield than the Beta Corporation bonds the Carters now hold? If so, which one(s)?
· Do you see any reason why Marlene should switch from her present bond holding into one of the other issues? If so, which swap candidate would be the best choice? Why?
Case Problem 11.2 Grace Decides to Immunize Her Portfolio
Grace Hesketh is the owner of an extremely successful dress boutique in downtown Chicago. Although high fashion is Grace’s first love, she’s also interested in investments, particularly bonds and other fixed-income securities. She actively manages her own investments and over time has built up a substantial portfolio of securities. She’s well versed on the latest investment techniques and is not afraid to apply those procedures to her own investments.
Grace has been playing with the idea of trying to immunize a big chunk of her bond portfolio. She’d like to cash out this part of her portfolio in seven years and use the proceeds to buy a vacation home in her home state of Oregon. To do this, she intends to use the $200,000 she now has invested in the following four corporate bonds (she currently has $50,000 invested in each one).
1. A 12-year, 7.5% bond that’s currently priced at $895
2. A 10-year, zero-coupon bond priced at $405
3. A 10-year, 10% bond priced at $1,080
4. A 15-year, 9.25% bond priced at $980
(Note: These are all noncallable, investment-grade, nonconvertible/straight bonds.)
1. Given the information provided, find the current yield and the promised yield for each bond in the portfolio. (Use annual compounding.)
2. Calculate the Macaulay and modified durations of each bond in the portfolio and indicate how the price of each bond would change if interest rates were to rise by 75 basis points. How would the price change if interest rates were to fall by 75 basis points?
3. Find the duration of the current four-bond portfolio. Given the seven-year target that Grace has set, would you consider this an immunized portfolio? Explain.
4. How could you lengthen or shorten the duration of this portfolio? What’s the shortest portfolio duration you can achieve? What’s the longest?
5. Using one or more of the four bonds described above, is it possible to come up with a $200,000 bond portfolio that will exhibit the duration characteristics Grace is looking for? Explain.
6. Using one or more of the four bonds, put together a $200,000 immunized portfolio for Grace. Because this portfolio will now be immunized, will Grace be able to treat it as a buy-and-hold portfolio-one she can put away and forget about? Explain.