This project is focused on the LUV 5.250% 04-May-2025 bond (ISIN: US844741BJ60), and asks you to perform tasks that would be typical of someone working within the fixed-income sector as a quant / trader (section A), credit analyst (section B), or portfolio manager (section C). Each section is worth 10 marks.

Your first task is to access the security description from Reuters Eikon or Bloomberg. Evidence of this should be included in the appendix of your submission

Section A: Fixed Income Security Valuation

In addition to the security description, I would like you to make some assumptions to simplify your task of pricing this security. Assume that the security pays an annual coupon and that you are pricing the security on 04-May-2021. In addition, the only date on which the embedded option can be exercised is 04-May-2024 (i.e. ignore the 04-Apr-2025 date stated in the description). You should also assume that interest rate volatility is 15% and that interest rates follow a lognormal model, with an equal probability of an increase and decrease in rates each year.

The relevant USD-denominated benchmark par curve is as follows:

Maturity (Years)     Par Rate 

1                              0.102%

2                               0.139%

3                               0.214%

4                               0.339%

5                               0.464%

i.   Determine the price of this security (as a % of face value) assuming that OAS is equal to 110 bps. Briefly explain why the price you have calculated will not precisely match the true theoretical price.

ii.  Determine the value of the embedded option in this security.

iii. Compute an appropriate measure of duration and convexity for this security. You should clearly state which measure you have selected and briefly explain why.

An Excel spreadsheet clearly showing your interest rate tree, binomial pricing model, and associated calculations should be submitted for this section.

Section B: Credit Analysis

Using the method of traditional credit analysis, write a report (1,500-word limit) to appraise the credit risk of this security. While you may comment on the other C’s, I would expect you to focus on the Capacity of the firm to repay debt. Ensure that you highlight the key factors that would impact your judgement of credit risk. You should end your report by evaluating whether Moody’s current credit rating for this issue is justified.

Section C: Investment Decision

As an Australian institutional portfolio manager you have a limited universe of possible investment choices in which to invest A$100 million of client funds. Your investment universe consists of the following three bonds:  

·      LUV                5.250% 04-May-2025 bond      (ISIN: US844741BJ60)

·      ULVR           2.900% 05-May-2027 bond      (ISIN: US904764AY33)

·      AUGV           0.500% 21-Sep-2026 bond        (ISIN: AU0000106411)

Which investment would you prefer?

Write a report (1,500-word limit) in which you carefully explain your investment choice. Your report should begin with a description “setting-the-scene” with regards your economic and market expectations – including your view on the current and future interest rate term structure - as this will impact your investment choice. You should incorporate an evaluation of the relative risk and return inherent in each bond, and relate this to your prevailing market view. A brief summary of how credit risk differs between the 3 bonds is sufficient. You can invest in a mixture of the bonds but should justify why this is appropriate given your expectations.