MGT201 Financial Management GDB Solution Fall 2012

Suppose, you are working as an investment consultant in a consultancy firm and most of your clients are habitual investors, who are maintaining their own portfolios comprising of various combinations of stocks and bonds.

Mr. Zahid, a habitual investor comes to you for consulting about adding one more potential investing option to his existing portfolio. Currently, as per your analysis, there are two bonds available in the market with the following data:

 

 

Bond A

Bond B

Maturity

3 years

8 years

Coupon payment

10% Annual

10% Semiannual

Yield

6.23%

9.8%

 

*Note: Interest rate fluctuations are high in the market

 

Required:

  • Suggest Mr. Zahid, who is interested to add only one bond to his portfolio about the suitable bond for his portfolio.
  • Support your choice by elaborating the reason on which the suggested bond is considered as a preferred option.

Solution:

Bond A is better. Keeping in mind the following points:

Maturity: Shorter maturities have less risk, so their interest rates don’t have to be as high as long-term maturities to attract buyers.
The longer the time to maturity for a bond, the greater the risk that the issuing company will experience financial trouble.

Coupon Payment: A bond with semiannual payments would have a higher price than a bond with annual payments when they both are selling at a premium.

In general, bonds with semiannual payments are more sensitive to changes in market interest rates. For the same amount of decline in market interest rates, bonds with semiannual payments tend to see more price increases.
Hence the one with annual payments is better.

Yield: If you purchase a higher grade, lower yield bond, you are exposed to less default risk, and you have a higher chance of getting all of the promised coupon payments and the per value if you hold the bond to maturity.

 

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