An investor is considering adding three new securities to his internationally fo

Question

An investor is considering adding three new securities to his internationally focused fixed-income portfolio. The securities under consideration are as follows 01-year U.S. Treasury note (noncallable) Baa rated corporate bond (callable) 10-year mortgage-backed security (MBS) (callable; government-backed collateral) The investor wil invest equally in all three securities being analyzed or will invest in none of them at this time. He will make the added investment provided that the expected spread/premium of the equally weighted investment is at least 0.5 percent (50 bps) over the similar-term Treasury bond. The investor has gathered the following information: Real risk-free interest rate Current inflation rate Spread of 10-year over 1-year Treasury note Long-term iation expectation 10-yr MBS prepayment risk spread (over 10-year Treasurics)* 10-yr call risk spread 10-yr BBB credit risk spread (over 10-year Treasuries) This spread implicitly includes a maturity premium in relation to the 1-year T-note as well as compensation for prepayment risk. 1.2% 2.2% 1.0% 2.6% 95 bps 80 bps 90 bps TASK: Using only the information given, address the following problems using the risk premium approach: A. Calculate the expected return that an equal-weighted investment in the three securities could provide B. Calculate the expected total risk premium of the three securities, and determine the investor's probable course of action

Explanation / Answer

Solution:

We first need to find the expected return through adding relevant risk premium for each type of security:

1) 1-year Treasury Note (Non-Callable)

Expected Return = Real Risk free rate + Current Inflation Rate = 1.2% + 2.2% = 3.40%

(Proxy for Inflation premium should be Current Inflation for Short Term (<=1 Year) & Long Term Inflation Expectation for 10 year securities)

2) 10-Year BBB Corporate Bond (Callable)

Expected Return = Real Risk free rate + Long Term Inflation Rate + Maturity Premium + Credit Risk Premium + Call Risk Premium

E.R = 1.2% + 2.6% + 1% + 0.9% + 0.8% = 6.50%

3) 10-Year MBS Bond (Callable)

Expected Return = Real Risk free rate + Long Term Inflation Rate + Credit Risk Premium + Call Risk Premium

E.R = 1.2% + 2.6% + 0.95% + 0.8% = 5.55%

Solution A) Expected return in equal weighted investment = (1/3*3.4%) + (1/3*6.5%) +(1/3*5.5%)

= 1.13% + 2.17% + 1.85% = 5.15%

Solution B)

Expected Risk Premium is simply the Expected Return found in A) minus Risk Free Rate

Therefore,

ERP for 1 Year Treasury Note = 3.4% - 1.2% = 2.2%

ERP for 10 Year BBB Bond = 6.5% - 1.2% = 5.3%

ERP for 10 Year MBS Bond = 5.55% - 1.2% = 4.35%

Now, to determine investors probable course of action,

First calculate,

10 - Year Treasy Bond Return = Risk Free Rate + Long Term Inflation + Treasury Spread (10 year over 1 year)

= 1.2% + 2.6% + 1% = 4.8%

Hence, Expected spread of Investment Strategy over Treasury Bond Return = 5.15% - 4.80% = 0.35% (35 bps)

Since this is less than the minimum requirement of 0.50%, the investor will NOT INVEST in this strategy

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