Question

-Suppose you are the owner of a large portfolio of long-term bonds in the health care industry and you believe that in the next three years, all healthcare will be socialized to the public sector. You anticipate that the profits of most healthcare companies will suffer immensely from this new path. If the market agrees with your assessment of the future, what would you anticipate would be the near term consequences for your bond portfolio? Why would this happen and why now, when the change to socialized medicine is three years away? How could you use options on these bonds to guard against lose?

Answer 1

If the profit are anticipated to suffer immensely, the bonds will become more risky to the investor. This is because bonds required period interest payments, and repayment of face value on maturity. Declining profits will make the payments on the bonds uncertain, as there is higher chance of default on the bond payments.

If the bonds become more risky, the yields on the bonds will rise. This is because investors require a higher return for riskier bonds. If the yields rise, the bond prices will fall. This is because bond yields and prices are inversely related.

In this case, if the market agrees with your assessment of the future, the bond prices will fall, resulting in a decline in the value of the bond portfolio.

This would happen now, even thought he change to socialized medicine is three years away. This is because the market will incorporate all new information into the prices immediately, and not at the future time of the event.

To guard against loss, I could buy put options on the bonds to lock into a sale price for the bonds.