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Submitted by:
Aniruddha Shinde | B18071
ANIRUDDHA SHINDE| B18071
CASE BACKGROUND
Atlas investment management is the financial advisory firm to the Green Hills golf
club for whom they manage the fixed income portfolio of around $600 million. The
board of trustees give the target requirement to the Atlas and ask they to suggest
some bonds that will fit into their requirement. Generally, all these target were
derived from evaluating the performance of the fund looking backward and its
prospective looking forward. And these targets are medium term targets.
Though most of the suggestions were of the bonds for one year holding Green hills
tend to hold on to them for multiple years. Main focus of these investment was to
invest into less risky options. But with changing market scenarios they are gradually
ready to increase the risk appetite by small margin and are expecting the high
returns.
During this year they are expecting the options with high returns and low risk. In the
internal meeting the analysts came up with the three major options that they think
can be the fit for the solution to the green hills requirement.
The task in front of the team is to evaluate all the three options for their returns and
possible risk attached to it. And which one would yield maximum returns for the
short duration with minimum risks.
ANIRUDDHA SHINDE| B18071
What should be the investment suggestion for the green hills according to the
returns they are looking for and the risk they are willing to take?
Atlas is tasked with the suggesting the investment options to the trustees of Green
Hills and they are expecting the bonds which will provide high returns on minimum
risk. The team came up with three options with wide range of returns from 3.625% to
11.25%.
The risk attached to these option was also in the varying range as their returns are.
Also the credit ratings are also ranging from AAA to CC i.e. again there is lot of
variation there too.
So one of the financial problem in front of the team to evaluate the risks attached
and incomes and come up with the suggestion.
These are the bonds issued by treasury department of the government hence are
government liabilities. The interest rate is fixed at the time of issuance based on the
market conditions which are constant till maturity in case of conventional bonds, so
any kind of price hike, inflation will reduce the real value of that return earned.
Other government policies like new bonds with better interest rate, policies aiding
other forms of investment will work against the current issued bonds. So change of
government or drastic change in financial policies will have considerable impact on
the net value of the bonds.
ANIRUDDHA SHINDE| B18071
Interest rates and bond prices have an inverse relationship; as interest rates fall, the
price of bonds trading in the marketplace generally rises. Conversely, when interest
rates rise, the price of bonds tends to go down. As the interest rate in the market
goes down on the new bonds and or on other investment, the investors try to move
their money toward the already existing bonds with relatively higher rate of return.
This increased demand may lead to increase in prices of the bonds.
On the flipside of which if the market interest rate goes up from the return on bonds
they many investors will start dumping their bonds to liquidate the money to invest
into other options which will ultimately lower the prices of those bonds in the
market. Thus analysing this risks before investing and having a proper hedging in
place is on the problems in front of the investors.
Also in case of callable bonds there will be investment risk of loss of investment
opportunities as in issuer may call back the bonds and give investor the cash and he
might end up with liquid cash and no god enough option to invest which will give
same rate of return with similar risk factor.
One major risk of corporate bonds is a credit risk / default. If the issuer goes out of
business, the investor may not receive not only the interest payments but also the
principal amount invested which is huge amount generally.
So this is very important factor to consider while investing, how to evaluate the credit
worthiness of the issuer. Though there are majors like credit ratings but how reliable
are they and what all other possible options they should consider to judge.
Here few options have very coupon rate but the credit rating is not so good this
contrasts with bonds that have been issued by a government with a high credit
rating, as this entity could theoretically increase taxes to make payments to
bondholders.
ANIRUDDHA SHINDE| B18071
So what should be the trade off point to settle with amount of risk and expected
return.
Involvement of reinvestment risk and what can be the hedging for this issue?
All these options are very different from each other in terms of the interest rate they
offer and various risks attached to them.
Important factors that needed to be considered while valuing the bonds are:
1. Coupon rate
2. Price
3. Yield to maturity ratio
4. Maturity period
5. Interest rate sensitivity
6. Risk of default
7. Reinvestment risk
Coupon rate:
Coupon rate is nothing but rate of interest that the bond will return. In case of these
bonds, it is fixed and given semi-annually.
A coupon is stated as a nominal percentage of the par value (principal amount) of the
bond. Each coupon is redeemable per period for that percentage.
ANIRUDDHA SHINDE| B18071
As the green hills is expecting higher returns this is one of the important factor in the
evaluation.
From the available options Trump Atlantic city provides the highest returns with
coupon rate of 11.250% and US bills lowest i.e. 3.625%. And other two options lie in
between with return rate of 7.875% and 7.6%.
Price:
Bonds have a face value and a market value. Generally, face value of the bonds is 100
and market value varies based on the return and demand for that bond.
Price is one of the important factor to be considered as it will decide the number of
units that can be purchased with given amount of capital which in turn will affect the
net profit from the investment.
Here in the four available options highest is GE capital with $112.799 as it high good
enough return with very good credit rating which will reduce the credit risk attached
whereas Trump Atlantic city is the cheapest one with $62.75, though return for this is
quite high but credit risk is also high as they have the credit rating of CC which is very
low compared to other options.
Also the investors are not willing to take risk this might not be the best choice for
them.
P = Price at Time 0
PMT(Tn) = Coupon Payment at Time N
FV = Future Value, Par Value, Principal Value
R = Yield to Maturity, Market Interest Rates
N = Number of Periods
ANIRUDDHA SHINDE| B18071
Using this formula, we can calculate the bond price when YTM and other factors are
known.
Source: https://www.investopedia.com/terms/y/yieldtomaturity.asp
YTM
30.000%
25.000%
20.000%
15.000%
10.000%
5.000%
0.000%
GE Capi tal Motorol a Trump Atl a ntic US Bi l l s
Maturity period:
Bonds will have a number of periods to maturity. These are typically annual periods,
but may also be semi-annual or quarterly. The number of periods will equal the
number of coupon payments.
y = yield to maturity
Market Macaulay
Company Par Value price Coupon YTM Duration
GE Capital 100 112.799 7.875% 4.924% 499.090%
Motorola 100 103.455 7.600% 6.762% 499.070%
Trump Atlantic 100 62.75 11.25% 25.255% 1.607%
T-Note 100 101.062 3.625% 3.426% 599.385%
Convexity makes duration analysis more precise, by accounting for the change in
duration as the yield changes—hence, convexity is the 2 nd derivative of the price-yield
curve at the current price-yield point.
Convexity increases as yield to maturity decreases, and vice versa and lower the
convexity lower is the interest rate risk.
ANIRUDDHA SHINDE| B18071
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
1 2 3 4
YTM Convexity
From the above analysis we can see that all the options vary under different
parameters. Trump Atlantic has highest returns but with CC credit rating it is not safe
for preserving the principal compared to other options though it is doing good on
convexity analysis and the price is also low compared to others.
US bills are one of the safest options considering the credit rating but the return is
very low. With YTM of 3.426%, which makes them prone to interest rate risk.
Considering the requirements of Green Hills most viable option is GE capital it is
offering moderate return of 7.875% with very good credit ration and low interest risk.
It can also be suggested to invest some part of the capital into Motorola though their
credit rating is low compared to GE they have very good YTM and moderate coupon
rate.
So mixture of GE capital and Motorola with more inclination towards GE can be the
good investment option for the club.