TO 36 RELATE TO FIXED INCOME BENJAMIN STEWART AND MARTHA...

Questions 31 to 36 relate to Fixed Income Benjamin Stewart and Martha Long Case Scenario Benjamin Stewart and Martha Long are two fixed income analysts serving Wrap Associates, a wealth management firm. WA manages the portfolios of institutional clients. Senior portfolio manager, Rose Butler, is managing the investment portfolios of TEE Inc’s defined pension plan, which has a 30-year investment horizon, and First Capital, a commercial bank offering lending and borrowing credit facilities. Stewart and Long meet during their lunch hour to discuss a report they are preparing which will feature an analysis of the implications of supply and demand changes in primary corporate bond markets and the impact of secular changes in dominant product structures. The two analysts arrive at the following conclusions: Conclusion 1: An increase in the supply of investment-grade securities in the primary corporate bond market has been found to validate and thus increase secondary market valuations. Conclusion 2: There have been significant changes in the global market’s dominant product structures as the market itself has become structurally heterogeneous. Bullet and intermediate-term structures are now popular choices while investors holding long-term bonds can enjoy a reduction in sensitivity to interest rate risk. Long feels it is necessary to include a discussion of how the long- and short-term liquidity needs of investors are influencing portfolio management decisions in global credit markets. She notes that liquidity concerns of investors have driven them to reduce the demand for medium-term notes (MTNs) and small-sized issues. She observes that bid/ask spreads have generally decreased for large, well-known corporate issues and believes this is due to the fact they are high in demand. Upon the conclusion of their discussion, Stewart returns to his working space and collects spread and term to maturity data with respect to the credit curves of two US investment-grade issues (Exhibit). The issuers belong to the consumer discretionary industry and are rated ‘A’ and ‘Baa’ respectively. The relevant benchmark is the on-the run Treasury curve. Exhibit: Two U.S. Investment Grade Credit Curves Spread Over On-the-Run US Treasuries (bps) Years to maturity 2 5 10 30 A 70 80 125 200 Baa 110 135 185 265 Based on the data collected, Stewart advises Butler to implement a credit barbell strategy for both her clients in an effort to moderate portfolio risk. Stewart decides to expand her analysis by reading a report on the short-term economic outlook in the US. The report projects a recession following a decline in GDP over two consecutive fiscal quarters. The report also forecasts the central bank to take preemptive stimulatory policy measures. TEE’s pension plan has a stream of early retirement benefit obligations which need to be satisfied at regular intervals. However, the bulk of the obligations are due thirty years from today. Butler has asked Stewart to devise a liability funding solution. The analyst recommends a combination matched strategy for immunizing the liability stream. 31. What is the generally observed implication of Conclusion 1 on corporate: credit spreads? relative returns? A. decrease increase. B. increase increase. C. decrease decrease. 32. Conclusion 2 is most likely: A. correct. B. incorrect, with respect to the structure of the global credit market. C. incorrect with respect to the change in duration of long-term bonds. 33. Does the analysts’ evaluation of the impact of liquidity concerns on portfolio management decisions correspond to actual market observations? A. Yes. B. No, investors with higher liquidity needs demand premiums for MTNs. C. No, credit bid/ask spreads have decreased due to lower credit risk. 34. Considering the data in the Exhibit, is Stewart’s recommendation to Butler appropriate? B. Only with respect to TEE. C. Only with respect to First Capital. 35. Based on the forecasts of the economic report, Stewart should recommend an investment in investment-grade credit products with maturities which are: A. long-term only. B. short-term only. C. short- and intermediate-term. 36. An advantage of the immunization approach recommended to Butler over multiple liability immunization is: A. lower liability funding costs. B. liquidity needs are better met. C. lower reinvestment risk in earlier years.