Question

The following bond swaps could have been made in recent years as investors attempted to increase the total return on their portfolio.

From the information presented below, identify possible reason(s) that investors may have made each swap.

Short answer

Answer

a. In anticipation of decline in interest rate and long-term bond price

b. In anticipation of a capital gain on treasury notes or capital loss on the phone bond,

c. By being bearish on the bond market

d. To take a capital gain on government bond or to avoid capital loss on A1 bond.

e. A combination of possible reasons .

Step-by-step solution

Step by Step Solution Step 1: Explanation on the reason for swap ‘a’

Investors would make this if they anticipated a decline in interest rate and an increase in long-term bond price. This would provide him more opportunity for capital gain, more excellent call protection, and protection against declining reinvestment rates.

Explanation of the reason for swap ‘b’

Investor would have considered 24 basis point yield spread too narrow and hence would have anticipated capital gain on treasury notes or capital loss on the phone bond, if the spread between the two bonds widened to a more normal level. He may have also anticipated a decline in interest rates and wanted to maintain high current coupon income and have the better call protection of the Treasury note.

Explanation of the reason for swap ‘c’

Investors would have been bearish on the bond market. Since the YTM is locked in, the zero-coupon note would be extremely vulnerable to an increase-increase date.

Explanation of the reason for swap ‘d’

Since these two bonds are similar in most respects, the investor might have swapped to take a capital gain on government bonds or avoid capital loss on A1 bonds.

Explanation on the reason for swap ‘e’

A combination of possible reasons:

(i) If the appreciation potential of Z Mart convertible was no longer attractive

(ii) If the yield on a long term bonds were high

(iii) if the investor wanted to enjoy an increase in coupon income due to decline in rates