His firm TMP, is going to file in finals to manage $100 million in index bonds for a Foundation. The Foundation's investment committee has not decided which index to use as a benchmark and wants TMP to focus its presentation on selecting an index. TMP knows that the investment committee of this Foundation has adopted an aggressive investment policy with a long-term horizon and above-average risk tolerance. Relevant data of the indices that will be considered are presented below.

Mix

index 1 index 2 index 3

US Treasuries 50% 50% 80%

US Agencies 10 10 10

corporates

Investment grade 10 10 5

Below Investment grade 5 5 0

Mortgage-Backed (Resident) 20 25 5

yankee bonds 5 0 0

Total 100 100 100

Modified duration 5.0 8.0 8.0

Yield to Maturity 7.50% 8.05% 8.00%

Both the level and the volatility of the interest rate have been declining for the past few years. The committee believes these trends are unlikely to continue and wants to know how an indexed portfolio will perform under different interest rate scenarios. Two of these scenarios are:

i. A cycle in which the interest rate will decrease, but volatility will increase more and more ii. A cycle in which the interest rate will be flat from start to finish, but with high volatility

a. Using the data in the table, rank the three indices in order of relative attractiveness under each of the scenarios described above. Justify your selection b. Recommend and justify an index to the committee to be used as the benchmark portfolio. Use as input what you know about the Foundation's investment policy and your answer in part a. c. Assume that the committee has selected an index to be used as a benchmark and TMP has been hired as portfolio manager. Explain the practical problems associated with building an indexed fixed income portfolio.