One common goal among fixed-income portfolio managers is to earn high incremental returns on corporate bonds versus government bonds of comparable durations. The approach of some corporate-bond portfolio managers is to find and purchase those corporate bonds having the largest initial spreads over comparable-duration government bonds. John Ames, HFS’s fixedincome manager, believes that a more rigorous approach is required.

a. Recommend purchase of either Aaa or Aa bonds for a 1-year investment horizon given a goal of maximizing expected returns.

b. Ames chooses not to rely solely on initial spread relationships. His analytical framework considers a full range of other key variables likely to impact realized returns, including call provisions and potential changes in interest rates. Describe variables, in addition to those identified above, that Ames should include in his analysis and explain how each of these could cause realized incremental returns to differ from those indicated by initial spread relationships. P-963