Case Problem 10.1 Max and Veronica Develop a Bond Investment Program

Max and Veronica Shuman, along with their teenage sons, Terry and Thomas, live in Portland, Oregon. Max is a sales rep for a major medical firm, and Veronica is a personnel officer at a local bank. Together they earn an annual income of around $100,000. Max has just learned that his recently departed rich uncle has named him in his will to the tune of some $250,000 after taxes. Needless to say, the family is elated. Max intends to spend $50,000 of his inheritance on a number of long-overdue family items (like some badly needed remodeling of their kitchen and family room, the down payment on a new Porsche Boxster, and braces to correct Tom’s overbite). Max wants to invest the remaining $200,000 in various types of fixed-income securities.

Max and Veronica have no unusual income requirements or health problems. Their only investment objectives are that they want to achieve some capital appreciation, and they want to keep their funds fully invested for at least 20 years. They would rather not have to rely on their investments as a source of current income but want to maintain some liquidity in their portfolio just in case.

Questions

a. Describe the type of bond investment program you think the Shuman family should follow. In answering this question, give appropriate consideration to both return and risk factors.

b. List several types of bonds that you would recommend for their portfolio and briefly indicate why you would recommend each.

c. Using a recent issue of the Wall Street Journal, Barron’s, or an online source, construct a $200,000 bond portfolio for the Shuman family. Use real securities and select any bonds (or notes) you like, given the following ground rules:

  1. The portfolio must include at least one Treasury, one agency, and one corporate bond; also, in total, the portfolio must hold at least five but no more than eight bonds or notes.
  2. No more than 5% of the portfolio can be in short-term U.S. Treasury bills (but note that if you hold a T-bill, that limits your selections to just seven other notes/bonds).
  3. Ignore all transaction costs (i.e., invest the full $200,000) and assume all securities have par values of $1,000 (although they can be trading in the market at something other than par).
  4. Use the latest available quotes to determine how many bonds/notes/bills you can buy.

d. Prepare a schedule listing all the securities in your recommended portfolio. Use a form like the one shown below and include the information it calls for on each security in the portfolio.

e. In one brief paragraph, note the key investment attributes of your recommended portfolio and the investment objectives you hope to achieve with it.

Security

Latest Quoted Price

Number of Bonds Purchased

Amount Invested

Annual Coupon Income

Current Yield

Issuer-Coupon-Maturity

Example: U.S. Treas – 8½%-’18

1468/32

15

$21,937.50

$1,275

5.81%

1.

2.

3.

4.

5.

6.

7.

8.

Totals

$200,000.00

$  

%  

Bond: Bond are almost similar to stocks. Just like stocks, bonds also provide regular incomes

and capital gains to the investors. But on comparison with stocks, one can say that bonds are

less risky and provide high current Income.

(a)

Risk: Risk is nothing but the possibility that an actual outcome of an action varies from expected

outcome.

Return: Return is the compensation for baring risk and forgoing alternative investments

opportunities.

There is a direct relationship between Risk and Return. The more risk an investor under takes,

the more return he would expect. Say for example, An investor may be satisfied with less return

on a portfolio ranging from 1 year to 2 year gestation period but the same investor expect more

return if the gestation period is more than 10 years. This is because, Risk increases along with

the gestation period.

The only way in which an investor can reduce his risk is, by diversifying it. Say, if a portfolio

consist shares of 10 different countries, then even if one company underperforms such a loss

can be compensated with the better performance of other companies.

So, Shuman’s Family must follow a long Term, highly diversified and high return portfolio with an

investment objective of Capital appreciation, without obstructing the Ground rule of liquidity.

(b)

The following bonds fit the bid and suitable to the requirements:

(1) Treasury Bonds: The maturity period of these bonds lies between 2 to 3 years. By their

basic nature these bonds are marked as “full faith and credit” by U.S government. Such a

marking makes the bond very liquid in domestic and foreign market.

These bonds are very helpful for the investors who are concerned about the liquidity of the bonds

and risk averse.

Check list to match the requirement:

Whether suitable for long term investments?

Yes.

Whether liquid in nature?

Yes.

Scope for capital appreciation?

Varies.

Repayment guarantee?

Yes.

Tax advantage (with respect to periodic payments)?

No

(2) Zero Coupon Bonds: These bonds do not fetch periodic regular income but they fetch

capital gain. These bonds are issued at Discount and redeemed at par value or premiun.

The advantage of these kinds of bonds is, once the investor makes up his mind regarding capital

investment in zero coupon bonds, he need not worry about reinvestment of periodic returns till

the maturity period.

(2) Zero Coupon Bonds: These bonds do not fetch periodic regular income but they fetch

capital gain. These bonds are issued at Discount and redeemed at par value or premiun.

The advantage of these kinds of bonds is, once the investor makes up his mind regarding capital

investment in zero coupon bonds, he need not worry about reinvestment of periodic returns till

the maturity period.

Check list to match the requirement:

Whether suitable for long term investments?

Yes.

Whether liquid in nature?

Yes.

Scope for capital appreciation?

Yes.

Repayment guarantee?

Yes.

Tax advantage (with respect to periodic payments)?

No.

Note: Even though there is no actual interest income, Bond holders are liable to pay tax based on

Concept of ‘accrual Income’.

(3) Municipal Bonds: These bonds are generally issues by the state governments, local

authorities and political sub divisions. The peculiar feature of these bonds is that, a person other

than issuer undertakes to pay the bond holder in case of default on the part of issuer with respcet

to both the ‘periodic income’ and ‘capital appreciation’.

Check list to match the requirement:

Whether suitable for long term investments?

depends

Whether liquid in nature?

Yes.

Scope for capital appreciation?

Very less

Repayment guarantee?

Yes.

Tax advantage (with respect to periodic payments)?

Yes.

(4) Agency Bond: They are similar to treasury bonds. These Bonds are issued by organisations

and agencies of US government. The main difference between Treasury bonds and Agency

bonds is that, US treasury do not accept the obligation of Agency Bonds. The peculiar feature of

these bonds is that, the holders do not physically possess the ownership certificate.

Check list to match the requirement:

Whether suitable for long term investments?

depends

Whether liquid in nature?

Comparatively less.

Scope for capital appreciation?

Yes.

Repayment guarantee?

No.

Tax advantage (with respect to periodic payments)?

No.

The following types of bonds are not suitable due to the following reasons:

Name of

the Bond:

Reasons:

Mortgaged

Backed

Securities.

By the very nature of these securities, investors receive part of capital investment

in the form of periodic returns. It would tend to capital appropriation rather than

capital appreciation.

Hence not suitable for Shumans family.

Asset

Backed

Securities.

These securities’ are useful for short-term investments only. The maturity period

generally falls below 5 years.

Hence not suitable for Shumans family.

Corporate

Bonds.

Maturity period ranges between 25 to 40 years.

Hence not suitable for Shumans family.

Conclusion: Out of all different types of the above mentioned bonds, Zero Coupon Bonds best

serve the requirements of Shuman family on the following counts.

Requirements of Shumans family

Feature of zero Coupon

Bond

Shumans family is not expecting regular income but capital

appreciation

Pay nothing till issue matures

Shumans family is concerned about Liquidity

Highly liquid

Shumans family is planning to invest for 20 long years

Suitable for long term

investments.

(c)

We can construct profolio with given $200,000 in the following manner.

Security: Investments:

10%Treasury bond -$13,800

Agency bond -$25100

Corporate bond -$11500

Municipal Bond -$37200

Zero Coupon Bonds -$112400

Total -$200000

(d)

Compute annual coupon income for 10% treasury bonds:

=Par valueNumber of shares purchasedCoupoun rate

=$10001010%

=$1000100.1

=$1000

Follow the same methodology for all remaining bonds.

Security

Price

per lot.

Assume, each lot

consists 100 units.

Always on

Market Price.

Always on Par

Value of 1000$

income/price

Latest

Price

($)

Number of Bonds

Purchased.

($)

Amount

Invested.

($)

Annual Coupon

Income

($)

Current

Yield.

(%)

10%Treasury

bond

1,380.00

10

13,800

1,000

0.72

Agency bond

1,255.00

20

25,100

2,000

1.59

Corporate

bond

1,150.00

10

11,500

1,000

0.86

Municipal

Bond

1,240.00

30

37,200

3,000

2.41

Zero Coupon

Bonds.

802.85

140

112,400

NA

0.00

Total

200000

5.60

(e)

The main objective of the investment portfolio is “Capital Appreciation’. Capital appreciation is a

stated goal of all mutual funds and diversified portfolio. It is a rise in the asset value based on the

market price. An increase of a fund investment rising gradually based on the market price. The

capital appreciation is in the form of dividend and interest income etc.

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