Case Problem 11.1 The Bond Investment Decisions of Dave and Marlene Carter

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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.

Questions

Regarding the short-term trading opportunity:

What basic trading principle is involved in this situation?

If Marlenes 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?