Question

As a portfolio manager for an Barletta Bank, you are about to invest $10 Billion in one of four possible investments:
            ♦          12-year zero-coupon bonds issued by Boudreaux Boats;
            ♦          10-year 12%-coupon bonds issued by Boudreaux Boats;
            ♦          7-year 8%-coupon bonds issued by Boudreaux Boats;
          ♦          1-year commercial paper issued by Boudreaux Boats
                        (commercial paper is 1-year debt, like a bank issuing a 1-year CD.

You plan to maintain your investments for exactly one year. You anticipate that U.S. economic growth will increase substantially over the next year, while most other investors believe that the attached yield curve accurately reflects expectations for economic growth during the next year.        

Assuming your expectations about the economy are correct, how well will each of these 4 fixed-income investments perform over the next 1 year relative to each other? Which investment should you choose and why?

Answer 1

The investment options for the portfolio manager represents debt instruments issued by Boudreaux Boats over different maturity periods.

The instruments with higher maturity will have higher duration meaning that the particular instrument will be more sensitive to interest rate changes.

The portfolio manager anticipates the US Economic growth to increase substantially. This will result in higher interest rates in the economy. Interest Rates have an inverse relation with Bond prices. This means that an increase in interest rates will reduce the bond prices and value of portfolio and vice versa.

Instruments with longer duration will be more sensitive to interest rate changes.

As the portfolio manager expects interest rates to increase due to positive growth, this will lead to reduction in prices of all debt instruments. However, instruments with longer maturity will have a more negative impact of increased interest rates than instruments with shorter maturity due to higher senstitivity to interest rate changes.

As a result, the portfolio manager should choose to invest in 1 year commercial paper which has the shortest duration. The commercial paper will have least reduction in value as compared to other debt instruments. Moreover, by investing in one year commercial paper, the manager can use the proceeds after 1 year to buy new debt instruments with higher yields as interest rates will increase over the next year.

Overall, the order in which instruments will have higher returns are:

1 Year Commercial Paper (highest return)

7 Year Bond

10 Year Bond

12 Year Zero Coupon Bond (lowest return)