Question

Jaime Bond is a fixed income portfolio manager. He has the following investment alternatives:

a. AA Corporate-Alegre Vengo bond with a coupon rate of 5%. This bond is trading at $ 925.

      Jaime expects an increase of 40% in the price of this bond.

b. AA Corporate-de La Montana bond, selling for $ 850 with a 6% coupon rate. Target price is

     par.

     

More important info:     

Jaime investment horizon is 5 years.

Alegre Vengo and De La Montana bonds have the same duration.

               Required:

                              What bond would you recommend, why?

                              Back your arguments with numbers relevant to the situation.

Answer 1

AA Corporate-Alegre Vengo bond

Purchase price = 925

Selling price = (1+40%)*925 = 1295

Coupon payment = 5%*1000 = 50

time = 5 years

IRR of the investment = r

0 = -925+50/(1+r)^1+50/(1+r)^2+50/(1+r)^3+50/(1+r)^4+50/(1+r)^5+1295/(1+r)^5

Solving the above equation we get,

r = 11.74% pa (5-year CAGR)

AA Corporate-de La Montana bond

Purchase price = 850

Selling price = 1000 (par)

Coupon payment = 6%*1000 = 60

time = 5 years

IRR of the investment = r

0 = -850+60/(1+r)^1+60/(1+r)^2+60/(1+r)^3+60/(1+r)^4+60/(1+r)^5+1000/(1+r)^5

Solving the above equation we get,

r = 9.95% pa (5-year CAGR)

AA Corporate-Alegre Vengo bond has a higher return for the same rating as compared to AA Corporate-de La Montana bond

Jaime Bond should invest in AA Corporate-Alegre Vengo bond