Question

You work as the treasurer of a large manufacturing corporation where earnings are down substantially as a result of COVID-19. In an environment where interest rates are going to decline over the next three to six months, you want to invest in fixed-income securities to make as much money as possible for the firm. The board recommends investing in one of the following securities: • Three-month Treasury Bill • Twenty-year Corporate Bonds • Twenty-year zero-coupon Treasury Bonds

Describe a suitable strategy based on your knowledge of bond theory, which may allow the company to maximize its profit if it were to undertake one of these investments. Further, advise the board on what is best for the company at this time given your knowledge of other investment options in the market.

Answer 1

Whenever the market is going through a crisis, there is liquidity crunch in the market and the corporate sector revenue faces turbulence. Because of this epidemic COVID-19 almost all businesses have been facing issues and they are facing the crunch.

Suggestion:-

First, the board strategy is based on the negative relation between interest rates and bond prices. Thus ,if interest rates decline , bond prices will rise, and the firm will earn a capital gain. Second to maximize earning, the treasure should select bonds that will have the largest price turn for a given change in interest rates. Bond theorem 2 and 3 suggest that for a given change in interest rates, low-coupon, long term bonds will have the largest price turn. Thus, the treasurer should invest in the 20- year zero coupon treasury bond.

Generating "Earnings" from risky financial investments is not the firms line of business or one of its core competencies. The treasurer's primary investment function is to invest idle cash in safe investment such as money market instrument that have very low default and interest rate risk.

In other words, Long-term bonds carry substantially more interest rate risk than the short -term bonds and investors in long term bonds need to fully understand the magnitude of the risk involved as its not easy to predict the interest rate movements consistently.

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