Case Background

Ah Lee, a financial manager at a US based mid-sized manufacturing firm, has been caught off-guard before. To earn the most on excess cash, Ah Lee once bought five-year coupon Treasury bonds (a maturity longer than the firms liabilities) only to see interest rates rise. The loss when the Treasury bonds were sold did not make Ah Lees 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 bonds 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 spot interest rates, however, the expected realized compound yield (RCY) can be calculated in order to cope with the reinvestment problem. For a bond that pays annual coupons over n years, the appropriate calculation for the annualized return is:

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

Where the Total future dollar value is the sum of (1) the coupon payments, (2) the reinvestment value on each coupon, and (3) the value of the bond at the end of the holding period.

In estimating the future dollars from a bond investment, Ah Lee needs a forecast of the direction and level of future interest rates in order to calculate the RCY. At yesterdays investment meeting, Carlo stated his view 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 Carlos respect for his reasoned judgment, suggests Ah Lee use the current term structure to gauge interest rate expectations. He uses the following table from Federal Reserve Statistical Release H.15 to get current spot rates on one-, two-, three- and four-year constant maturity Treasury securities. (See table below).

Case Task

"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 investment." Ah Cheung also adds, If you follow Carols view, he also wants to see the reasons behind your agreement.

Ah Lees problem is to recommend the best investment strategy among the four 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:

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 Carlos forecast is the best because hell have no one to blame but himself if Ah Lee makes a recommendation based on the forecast.

Case Questions

Q1. Would Ah Lee go by Carols view on interest rate remain unchanged for the next 3 years? Why or why not? (25 Points)

(Note: Apart from HR issue that can affect Ah Lees choice, 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 in the coming 3 years. You should frame your discussion on interest rate view with current economic and market factors (such as ate cut after rate hike, inflation/deflation expectation, monetary/fiscal policy, trade war etc). Your interest rate view would directly affect your investment decision in Q3.)

Q2. Risk and Return analysis

(i) Analyse the durations of the 4 bonds. (you need to show details of your calculation) (10 Points)

(ii) Explain why duration matters in the analysis. (10 Points)

(Hint: You need to calculate the YTM of the 4 bonds in order to calculate the Duration. The discussion should also include companys asset and liability balance).

(i) Perform RCY analysis on the 4 bonds. (you need to show details of your calculation) (30 Points)

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

Q3. Based on Q1s interest rate expectation and Q2s calculations, explain your recommendation on the investment of $10 million? (25 Points)

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

Treasury constant maturities Spot Rate Today 1-month 1.58% 3-month 1.57% 6-month 1.58% 1-year 1.54% 2-year 1.61% 3-year 1.61% 4-year 1.63% 5-year 1.65% 7-year 1.75% 10-year 1.84% 20-year 2.16% 30-year 2.31% Bond Bond 1 Bond 2 Bond 3 Bond 4 Annual Coupon 0% 11.625% 5.5% 3.5% Current Price $882.50 $1403.39 $1107.59 $905.25 Maturity (yrs) 5 5 3 4 Treasury constant maturities Spot Rate Today 1-month 1.58% 3-month 1.57% 6-month 1.58% 1-year 1.54% 2-year 1.61% 3-year 1.61% 4-year 1.63% 5-year 1.65% 7-year 1.75% 10-year 1.84% 20-year 2.16% 30-year 2.31% Bond Bond 1 Bond 2 Bond 3 Bond 4 Annual Coupon 0% 11.625% 5.5% 3.5% Current Price $882.50 $1403.39 $1107.59 $905.25 Maturity (yrs) 5 5 3 4