Question

You are the manager of the bond portfolio of a pension fund. The policies of the fund allow for the use of active strategies in managing the bond portfolio. It appears that the economic cycle is beginning to mature, inflation is expected to accelerate, and, in an effort to contain the economic expansion, central bank policy is moving toward constraint. For each of the situations below, state which one of the two bonds you would prefer. Briefly justify your answer in each case.

a. Government of Canada (Canadian pay), 4% due in 2017, and priced at 101.25 to yield 3.50% to maturity;

or

Government of Canada (Canadian pay), 4% due in 2027, and priced at 95.75 to yield 4.19% to maturity.

b. Texas Power and Light Co., 5½% due in 2022, rated AAA, and priced at 85 to yield 8.1% to maturity;

or

Arizona Public Service Co., 5.45% due in 2022, rated A 2 , and priced at 80 to yield 9.1% to maturity.

c. Commonwealth Edison, 2¾% due in 2021, rated Baa, and priced at 81 to yield 7.2% to maturity;

or

Commonwealth Edison, 9⅜% due in 2021, rated Baa, and priced at 114 to yield 7.2% to maturity.

d. Shell Oil Co., 6¾% sinking fund debentures due in 2026, rated AAA (sinking fund begins in 2015 at par), and priced at 89 to yield 7.1% to maturity;

or

Warner-Lambert, 6⅞% sinking fund debentures due in 2026, rated AAA (sinking fund begins in 2016 at par), and priced at 95 to yield 7% to maturity.

e. Bank of Montreal (Canadian pay), 4% certificates of deposit due in 2014, rated AAA, and priced at 100 to yield 4% to maturity;

or

Bank of Montreal (Canadian pay), floating-rate notes due in 2018, rated AAA.

Coupon currently set at 3.7% and priced at 100 (coupon adjusted semiannually to .5% above the three-month Government of Canada Treasury bill rate).

Short answer

a. 2017 bond

b. Arizona Public Service Co

c. 9% coupon bond

d. Shell Oil Co.

e. Canadian Pay floating rates notes

Step-by-step solution

Explanation on the choice of bonds ‘a’

In a maturing economy, interest rates are likely to increase. In such a scenario shortening the duration of the portfolio is advisable. Hence 2017 bond is an advised choice.

Explanation of the choice of bonds ‘b’

Between Arizona and Texas Power, both have an almost equal coupon but since Arizona has lower duration and higher yield, it should be an advised choice.

Explanation on the choice of bonds ‘c’

In both the scenarios, the Common wealth edition's maturities are just the same. However, the coupon of 9% is much higher. This leads to a lower duration too. Hence the 9% coupon should be the preferred choice.

Explanation of the choice of bonds ‘d’

Between Warner-Lambert and Shell bonds, the latter will have a lower duration if the effect of the higher YTM and earlier start of sinking fund redemption dominates the lower coupon rate. Therefore the Shell bond should be a preferred choice.

Explanation on the choice of bonds ‘e’

Between the deposit and floating rate, the latter has a duration of 6 months hence the preferred choice should be the floating rate.