Case Problem 11.1 The Bond Investment Decisions of Dave and Marlene Carter LG 3
ID: 2786307 • Letter: C
Question
Case Problem 11.1 The Bond Investment Decisions of Dave and Marlene Carter
LG 3
LG 4
LG 6
Dave and Marlene Carter live in the Boston area, where Dave has a successful orthodontics practice. Dave and Marlene have built up a sizable investment portfolio and have always had a major portion of their investments in fixed-income securities. They adhere to a fairly aggressive investment posture and actively go after both attractive current income and substantial capital gains. Assume that it is now 2016 and Marlene is currently evaluating two investment decisions: one involves an addition to their portfolio, the other a revision to it.
The Carters’ first investment decision involves a short-term trading opportunity. In particular, Marlene has a chance to buy a 7.5%, 25-year bond that is currently priced at $852 to yield 9%; she feels that in two years the promised yield of the issue should drop to 8%.
The second is a bond swap. The Carters hold some Beta Corporation 7%, 2029 bonds that are currently priced at $785. They want to improve both current income and yield to maturity and are considering one of three issues as a possible swap candidate: (a) Dental Floss, Inc., 7.5%, 2041, currently priced at $780; (b) Root Canal Products of America, 6.5%, 2029, selling at $885; and (c) Kansas City Dental Insurance, 8%, 2030, priced at $950. All of the swap candidates are of comparable quality and have comparable issue characteristics.
Questions
Regarding the short-term trading opportunity:
What basic trading principle is involved in this situation?
If Marlene’s expectations are correct, what will the price of this bond be in two years?
What is the expected return on this investment?
Should this investment be made? Why?
Regarding the bond swap opportunity:
Compute the current yield and the promised yield (use semiannual compounding) for the bond the Carters currently hold and for each of the three swap candidates.
Do any of the swap candidates provide better current income and/or current yield than the Beta Corporation bonds the Carters now hold? If so, which one(s)?
Do you see any reason why Marlene should switch from her present bond holding into one of the other issues? If so, which swap candidate would be the best choice? Why?
Explanation / Answer
Questions
Regarding the short-term trading opportunity:
What basic trading principle is involved in this situation?
They want to trade on forecasted interest rate behavior
If Marlene’s expectations are correct, what will the price of this bond be in two years?
Given details:
Bond is currently priced at $852; interest rate 7.5%; Life 25 years; the bond is expected to yield 8% after two years.
A bond is a fixed-rate bearing security. The interest rate of the bond is a fixed, stated amount, but the bond's yield, which is the interest amount relative to the bond's current market price, fluctuates along with price. As the bond's price fluctuates, the price is described relative to the original face value.
We have to first calculate the face value (FV) of the bond.
Let the FV of the bond be ‘FV’. The formula for calculating PV is given below:
PV = (interest on bond x FV x present value annuity factor (PVAF) (1/(1+Yield))^25) + (FV x Present Value Factor (PVF) (1/(1+Yield))^25)
PVAF and PVF can be calculated using excel or it can be taken from the respective table from the textbook.
Therefore, 852= 0.075 x FV x PVAF (1/1.09)^25 + FV x PVF (1/1.09)^25
852= 0.075 x FV x 9.822 + 0.116 x FV
852= 0.73665FV+ 0.116FV
852= 0.852FV
FV= $1000.
As per Marlene’s expectations, the price of the bond in year 2 would be:
PV of bond= PV of coupon+ PV of Face Value
PV of bond = 1000 x 0.075 x PVAF (1/1.08)^23 + 1000 x PVF (1/1.08)^ 23
PV of bond = 75 x 10.37 + 1000 x 0.170
PV of bond =777.75 + 170 = $ 947.75
What is the expected return on this investment?
Expected return is calculated as follows
Current Price = Interest on bond x PVAF + PV of Capital Gain x PVF
852 = 75 * PVAF x%, 25 yrs + (1000-852) PVF x%, 25th yr
Yield to maturity= 9%
Should this investment be made? Why?
As shown above, the Price of the bond is expected to increase to $947.75 in 2 years time.
Therefore, Marlene can sell the bond at higher price.
PV of investment can be calculated as follows:
= Interest on bond x FV X PVAF 2yrs at 9% + 947.75 x PVF 2yrs at 9%
= $75 * PVAF 2yrs at 9% + 947.75 x PVF 2yrs at 9%
= $929.635
Since the current price is less than the present value of investment, Marlene should BUY the bond
Regarding the bond swap opportunity:
Compute the current yield and the promised yield (use semiannual compounding) for the bond the Carters currently hold and for each of the three swap candidates.
Here the FV == $1000
The current yield and Yield to Maturity (YTM) of the four bonds are calculated as below:
Current Yield = Annual payout as a percentage of the current market price you'll actually pay
YTM is the total return anticipated on a bond if the bond is held until the end of its lifetime.
Coupon Payment + (FV – Price)/N
YTM = ___________________________
(FV + Price)/2
Beta Corporation 7% 2023 bonds - Current Price = $785; Yield = 70/785 = 8.92% and YTM = 9.90%
Dental Floss Inc 7.5% 2035 bonds – Current price =$780; Yield = 75/780 = 9.62% and YTM = 9.89%
Root canal products 6.5% 2023 bonds – Current price = $885; Yield = 65/885 = 7.34% and YTM = 7.93%
Kansas City Dental Insurance 8% 2030, priced – Current price = $950; Yield = 80/950 =8.42% and YTM =8.46%
Do any of the swap candidates provide better current income and/or current yield than the Beta Corporation bonds the Carters now hold? If so, which one(s)?
Yes, Dental Floss Inc as shown above current yield is 9.62%
Do you see any reason why Marlene should switch from her present bond holding into one of the other issues? If so, which swap candidate would be the best choice? Why?
No, since YTM of Beta corporation is the highest at 9.9% and the bond is due in 2023, whereas others have less YTM.