Luther Industries needs to borrow $50 million in cash. Currently long-term AAA r

Question

Luther Industries needs to borrow $50 million in cash. Currently long-term AAA rates are 9%. Luther can borrow at 9.75% given its current credit rating. Luther is expecting interest rates to fall over the next few years, so it would prefer to borrow at the short-term rates and refinance after rates have dropped. Luther management is afraid, however, that its credit rating may fall which could greatly increase the spread the firm must pay on new borrowings. How can Luther benefit from the expected decline in future interest rates without exposure to the risk of the potential future changes to its credit ratings bring?

Explanation / Answer

The diversification benefits of bonds in a stock/ bond portfolio will likely persist. This feature, more than projected returns, justifies a strategic allocation to bonds. That said, lower projected returns from bonds and their diminished ability to generate high offsetting returns have important implications for downside risk and the asset allocation decision. If investors have a risk tolerance that is defined by a maximum tolerable loss, then their asset allocation should become more conservative and their return expectations must be lower. Conversely, if investors place a premium on generating higher returns, as opposed to lowering downside risk, and as a result are reducing their bond exposure in favor of more equities, they must be willing to tolerate more downside risk in their portfolios. Investors should recognize that lower expected bond returns have not altered the fundamental relationship between risk and return or the role that a strategic bond allocation has in reducing equity market volatility.

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