Question

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

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

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

b. BB Corporate-CC bond, selling for $ 850 with a 6% coupon rate. Target price is

     par.

     

More important info:     

Jo investment horizon is 5 years.

BB and CC bonds have the same duration.

Required:

What bond would you recommend, why?

                                Back your arguments with numbers relevant to the situation.

Answer 1

BB Corporate-BB 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)

BB Corporate-CC 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)

CC bond despite having a lower rating as compared to BB bond, is offering a CAGR of 9.95% as compared to 11.74% of BB bond.

Therefore it makes no sense to go for a lower-rated bond with a lower return.

Jo Bond should invest in BB bond without any second thoughts