Ah Lee, a financial manager at a US based mid-sized manufacturing firm, has been caught off-guard before. In an effort to earn the most on excess cash, Ah Lee once bought five-year US Treasury bonds (a maturity longer than the firm's liabilities) only to see interest rates rise. The loss when the Treasury bonds were sold did not make Ah Lee's supervisor, Carlo, Chief Financial Officer, very happy.

Ah Lee is now in a similar situation - Carlo has asked for a recommendation on the investment of another $10 million in excess cash.

Risk and Return using RCY

The risk of unexpected changes in interest rates is a given with coupon-paying bonds. Even if the bonds are held to maturity, there is reinvestment risk. A bond's exposure to interest rate risk depends on the size and the number of coupon payments made to the bondholder. The realized return from a bond depends on the rates at which the coupons are invested; the rates can only be estimated at the time the bond is purchased.

Given estimates of futures interest rates, however, the expected realized compound yield (RCY) can be calculated in order to cope with the reinvestment problem. For a bond that paysannual couponsover n years, the appropriate calculation for the annualized return is:

RCY = [(Total future dollar value/Purchase price of bond)1/n- 1].

The total future dollar value from the investment includes the coupon payments, the earnings on each coupon, and the value of the bond at the end of the holding period.

In estimating the future dollars from a bond purchase,Ah Lee needs a forecast of the direction and level of future interest rates.At yesterday's investment meeting,Carlo stated his belief that interest rates would remain unchanged for the next three years because of an unchanging expected inflation rate.Ah Cheung, another financial manager at the firm and someone that has earned Carlo's respect for his reasoned judgment, suggests Ah Lee use the current term structure to gauge interest rate expectations. He uses the following table fromFederal Reserve Statistical Release H.15to get current spot rates on one-, two-, and three-year constant maturity Treasury securities.

Treasury constant maturities

Spot Rate Today

1-year

1.54%

2-year

1.61%

3-year

1.61%

4-year

1.63%

5-year

1.65%

7-year

1.75%

"Carlo will accept a recommendation different than his own only if it is justified by analysis," advises Ah Cheung. "Well-reasoned analysis is an opportunity to gain back some of Carlo' trust, which was lost after your last bond purchase."

Ah Lee's problem is to recommend the best investment among three different US Treasury bonds.The $10 million investment will be liquidated in three years to help repay a bank loan charging a fixed rate interest at 8.50% per year. The bonds, each with a $1,000 par value and annual convention, are described as following:

Bond

Annual Coupon

Current Price

Maturity (yrs)

Bond 1

0%

$882.50

5

Bond 2

11.625%

$1403.39

5

Bond 3

5.5%

$1107.59

3

Note: This is an important recommendation for Ah Lee that can affect his career. Although no one knows the future course of interest rates (not even Carlo),Ah Lee knows it is essential to consider the impact of an unexpected change in interest rates on each of the bonds. To Ah Lee, it is probably least risky to assume Carlo's forecast is the best because he'll have no one to blame but himself if Ah Lee makes a recommendation based on the forecast.

Questions

1. Would Ah Lee go by Carol's view on interest rate remain unchanged for the next 3 years? Why or why not? (20 Points)

(Note: I am open to what you want to discuss about the interest rate term structure over the next 3 years. Whether you agree or disagree with the view that term structure will remain the same Your interest rate view would directly affect your investment decision.)

2. Risk and Return analysis

(i) Analyse the durations of the 3 bonds and why does that matter in the analysis? Explain. (20 Points)

(Hint: You need to calculate the YTM of the 3 bonds in order to calculate the Duration).

(ii) Perform RCY analysis on the 3 bonds (40 Points)

(Hint: Make use of spot rates to calculate the corresponding forward rates for coupon reinvestment calculation.)

(Hint: You also need forward rates for future Bond price)

3. Explain your recommendation on the investment of $10 million? (20 Points)

(Hint: Your recommendation does not only base on interest rate view and the RCY/duration analysis). You may also consider the funding cost of the company currently paying for its current liability.)