Question
Companies often buy bonds to meet a future liability or cash outlay. Such an investment is called a dedicated portfolio because the proceeds of the
Companies often buy bonds to meet a future liability or cash outlay. Such an investment is called a dedicated portfolio because the proceeds of the portfolio are dedicated to the future liability. In such a case, the portfolio is subject to reinvestment risk. Reinvestment risk occurs because the company will be reinvesting the coupon payments it receives. If the YTM on similar bonds falls, these coupon payments will be reinvested at a lower interest rate, which will result in a portfolio value that is lower than desired at maturity. Of course, if interest rates increase, the portfolio value at maturity will be higher than needed.
Suppose Ice Cubes, Inc., has the following liability due in five years. The company is going to buy five-year bonds today to meet the future obligation. The liability and current YTM are below.
Amount of liability: | $100,000,000% |
Current YTM: | 8% |
a.At the current YTM, what is the face value of the bonds the company has to purchase today to meet its future obligation? Assume that the bonds in the relevant range will have the same coupon rate as the current YTM and these bonds make semiannual coupon payments.
b.Assume that the interest rates remain constant for the next five years. Thus, when the company reinvests the coupon payments, it will reinvest at the current YTM. What is the value of the portfolio in five years?
c.Assume that immediately after the company purchases the bonds, interest rates either rise or fall by 1 percent. What is the value of the portfolio in five years under these circumstances?
D. Assume that the company has decided to buy and hold, Treasury STRIPS with maturity of 5 years. Will this strategy work? Is this portfolio fully immunized?
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