22. One common goal among fixed-income 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 fixed-income manager, believes that a more rigorous approach is required if incremental returns are to be maximized.

The table below presents data relating to one set of corporate/government spread relationships present in the market at a given date:

a. Recommend purchase of either Aaa or Aa bonds for a one-year investment horizon given a goal of maximizing incremental returns. Show your calculations.
(Base your decision only on the information presented in the table.)
Ames chooses not to rely solely on initial spread relationships. His analytical framework considers a full range of other key variables likely to affect realized incremental returns including:
• Call provisions • Potential changes in interest rates

b. Describe two variables, in addition to those iden tified above, that Ames should include in his analysis, and explain how each of those two variables could cause realized incremental returns to differ from those indicated by initial spread relationships.

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Current and Expected Spreads and Durations of High-Grade Corporate Bonds (One-Year Horizon) Initial Spread over Governments Expected Duration One Year from Now Bond Rating Expected Horizon Spread Initial Duration Aaa Aa 31 basis points 31 basis points 4 years 40 basis points 50 basis points 4 years 3.1 years 3.1 years