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:
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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