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The following information relates to Questions 1–6 Cécile Perreaux is a junior analyst for an international wealth management firm

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The following information relates to Questions 1–6

Cécile Perreaux is a junior analyst for an international wealth management firm. Her supervisor, Margit Daasvand, asks Perreaux to evaluate three fixed-income funds as part of the firm’s global fixed-income offerings. Selected financial data for the funds Aschel, Permot, and Rosaiso are presented in Exhibit 1. In Perreaux’s initial review, she assumes that there is no reinvestment income and that the yield curve remains unchanged.

EXHIBIT 1 — Selected Data on Fixed-Income Funds

	Aschel	Permot	Rosaiso
Current average bond price	$117.00	$91.50	$94.60
Expected average bond price in one year (end of Year 1)	$114.00	$96.00	$97.00
Average modified duration	7.07	7.38	6.99
Average annual coupon payment	$3.63	$6.07	$6.36
Present value of portfolio’s assets (millions)	$136.33	$68.50	$74.38
Bond type”
Fixed-coupon bonds	95%	38%	62%
Floating-coupon bonds	2%	34%	17%
Inflation-linked bonds	3%	28%	21%
Quality”
AAA	65%	15%	20%
BBB	35%	65%	50%
B	0%	20%	20%
Not rated	0%	0%	10%
Value of portfolio’s equity (millions)	$94.33
Value of borrowed funds (millions)	$42.00
Borrowing rate	2.80%
Return on invested funds	6.20%

 

* Bond type and Quality are shown as a percentage of total for each fund.

After further review of the composition of each of the funds, Perreaux notes the following.

Note 1: A schel is the only fund of the three that uses leverage.

Note 2: R osaiso is the only fund of the three that holds a significant number of bonds with embedded options.

Daasvand asks Perreaux to analyze immunization approaches to liability-based mandates for a meeting with Villash Foundation. Villash Foundation is a tax-exempt client. Prior to the meeting,Perreaux identifies what she considers to be two key features of a cash flow–matching approach.

Feature 1: It requires no yield curve assumptions.

Feature 2: Cash flows come from coupons and liquidating bond portfolio positions. Two years later, Daasvand learns that Villash Foundation needs $5,000,000 in cash to meet liabilities. She asks Perreaux to analyze two bonds for possible liquidation. Selected data on the two bonds are presented in Exhibit 2.

EXHIBIT 2 — Selected Data for Bonds 1 and 2

	Bond 1		Bond 2
Current market value	$5,000,000		$5,000,000
Capital gain/loss	400,000		-400,000
Coupon rate	2.05%		2.05%
Remaining maturity	8 years		8 years
Investment view	Overvalued		Undervalued
Income tax rate		39%
Capital gains tax rate		30%

 

1. Based on Exhibit 1, which fund provides the highest level of protection against inflation for coupon payments?

A. Aschel

B. Permot

C. Rosaiso

2. Based on Exhibit 1, the rolling yield of Aschel over a one-year investment horizon is closest to:

A. −2.56%.

B. 0.54%.

C. 5.66%.

3. The levered portfolio return for Aschel is closest to:

A. 7.25%.

B. 7.71%.

C. 8.96%.

4. Based on Note 2, Rosaiso is the only fund for which the expected change in price based on the investor’s views of yields and yield spreads should be calculated using:

A. convexity.

B. modified duration.

C. effective duration.

5. Is Perreaux correct with respect to key features of cash flow matching?

A. Yes.

B. No, only Feature 1 is correct.

C. No, only Feature 2 is correct.

6. Based on Exhibit 2, the optimal strategy to meet Villash Foundation’s cash needs is the sale of:

A. 100% of Bond 1.

B. 100% of Bond 2.

C. 50% of Bond 1 and 50% of Bond 2.

The following information relates to Questions 7–11

Celia Deveraux is chief investment officer for the Topanga Investors Fund, which invests in equities and fixed income. The clients in the fund are all taxable investors. The fixed-income allocation includes a domestic (US) bond portfolio and an externally managed global bond portfolio.

The domestic bond portfolio has a total return mandate, which specifies a long-term return objective of 25 basis points (bps) over the benchmark index. Relative to the benchmark, small deviations in sector weightings are permitted, such risk factors as duration must closely match, and tracking error is expected to be less than 50 bps per year.

The objectives for the domestic bond portfolio include the ability to fund future liabilities, protect interest income from short-term inflation, and minimize the correlation with the fund’s equity portfolio. The correlation between the fund’s domestic bond portfolio and equity portfolio is currently 0.14. Deveraux plans to reduce the fund’s equity allocation and increase the allocation to the domestic bond portfolio. She reviews two possible investment strategies.

Strategy 1: Purchase AAA rated fixed-coupon corporate bonds with a modified duration of two years and a correlation coefficient with the equity portfolio of −0.15.

Strategy 2: Purchase US government agency floating-coupon bonds with a modified duration of one month and a correlation coefficient with the equity portfolio of −0.10.

Regarding the purchase of corporate bonds, Foster collects relevant data, which are presented in Exhibit 1.

EXHIBIT 1 — Selected Data on Three US Corporate Bonds

Bond Characteristics	Bond 1	Bond 2	Bond 3
Credit quality	AA	AA	A
Issue size ($ millions)	100	75	75
Maturity (years)	5	7	7
Total issuance outstanding ($ millions)	1,000	1,500	1,000
Months since issuance	New issue	3	6

 

Deveraux and Foster review the total expected 12-month return (assuming no reinvestment income) for the global bond portfolio. Selected financial data are presented in Exhibit 2.

EXHIBIT 2 — Selected Data on Global Bond Portfolio

Notional principal of portfolio (in millions)	€200
Average bond coupon payment (per €100 par value)	€2.25
Coupon frequency	Annual
Current average bond price	€98.45
Expected average bond price in one year (assuming an unchanged yield curve)	€98.62
Average bond convexity	22
Average bond modified duration	5.19
Expected average yield and yield spread change	0.15%
Expected credit losses	0.13%
Expected currency gains (€ appreciation vs. $)	0.65%

 

Deveraux contemplates adding a new manager to the global bond portfolio. She reviews three proposals and determines that each manager uses the same index as its benchmark but pursues a different total return approach, as presented in Exhibit 3.

EXHIBIT 3. New Manager Proposals Fixed-Income Portfolio Characteristics

Sector Weights (%)	Manager A	Manager B	Manager C	Index
Government	53.5	52.5	47.8	54.1
Agency/quasi-agency	16.2	16.4	13.4	16.0
Corporate	20.0	22.2	25.1	19.8
MBS	10.3	8.9	13.7	10.1
Risk and Return Characteristics	Manager A	Manager B	Manager C	Index
Average maturity (years)	7.63	7.84	8.55	7.56
Modified duration (years)	5.23	5.25	6.16	5.22
Average yield (%)	1.98	2.08	2.12	1.99
Turnover (%)	207	220	290	205

 

7. Which approach to its total return mandate is the fund’s domestic bond portfolio most likely to use?

A. Pure indexing

B. Enhanced indexing

C. Active management

8. Strategy 2 is most likely preferred to Strategy 1 for meeting the objective of:

A. protecting inflation.

B. funding future liabilities.

C. minimizing the correlation of the fund’s domestic bond portfolio and equity portfolio.

9. Based on Exhibit 1, which bond most likely has the highest liquidity premium?

A. Bond 1

B. Bond 2

C. Bond 3

10. Based on Exhibit 2, the total expected return of the fund’s global bond portfolio is closest to:

A. 0.90%.

B. 2.20%.

C. 3.76%.

11. Based on Exhibit 3, which manager is most likely to have an active management total return mandate?

A. Manager A

B. Manager B

C. Manager C