Robert Wallace began investing in bonds six months ago through tax-exempt munici

Question

Robert Wallace began investing in bonds six months ago through tax-exempt municipal securities. His intent at that point in time was to reduce the tax obligation related to his investment portfolio. However, he began to notice that the price of his bonds changed as interest rates changed, and he even took advantage of this phenomenon by cashing in a couple of his 10-year munis early as interest rates dropped and capital gains were available for the taking. Because of the bond price-interest rate sensitivity relationship he observed, Robert decided to get more aggressive in his bond investment strategy. He didn't particularly like U.S. government bonds as they pay a lower coupon rate because they have no credit risk. He decided to go for maximum yield on lower-quality corporate bonds wrhile also waiting for interest rates to go down and bond prices to go up. He bought five such 15-year corporate bonds. In doing a six-months review of Robert Wallace s portfolio, his investment advisor, Brian Gonzalez, said his interest rate strategy was fine, but he was making a fundamental mistake in his type of bond choice based on the "Six Bond-Pricing Rules" found in this chapter. He proceeded to lend him a copy of Hirt and Block's Fundamentals of Investment Management. What mistake was Robert Wallace making? Also, from a tax minimization viewpoint, what mistake was Robert Wallace making in the trading of his municipal bonds?

Explanation / Answer

Robert Wallace is making funadmanetal mistake that the He is taking sisgnificant credit risk by buying the Junk Corpoate Bonds . He could buy givernment binds with high years to maturity and behfit from fall in interest rates

As hihs strategy is to make capital gains , he should therefore avoid taking credit risk and and focus high qaulity papers with high durations

Percentage change in price = % change in interest rates* Duration

As the capital gains in Munis are not tax exempt , thus he would not be able to minimize tax liability

When buying muni bonds on the secondary market, investors must be aware that bonds purchased at a discount (less than par value), will be taxed upon redemption at the capital gains rate. Note that this tax does not apply to the coupon payments, but only the principal of the bond.

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