TO 36 RELATE TO FIXED INCOME MARTIN ALEXANDER CASE SCENAR...

Questions 31 to 36 relate to Fixed Income Martin Alexander Case Scenario Martin Alexander works for a renowned credit rating agency as a security appraiser & research analyst. Alexander has worked with his colleagues in the bond appraisal of numerous US-based, as well as international issuers. Consequently, he has become adept at performing a comprehensive analysis of the factors that influence the financial standing of a firm. For his latest assignment, Alexander is studying how a country’s interest rate is affected by currency exchange rate changes. In particular, he is assessing the following: § Changes in the level of long-term interest rates relative to short-term rates as expressed in the yield curve. § The correlation between economic growth and defaults, and between defaults and credit spreads. § The relationship of total debt as a multiple of EBITDA for different market sectors of interest. Alexander uses this method to determine how investment-grade bonds would perform relative to high-yield bonds. He gathers the data presented in Exhibit 1 to perform an accurate comparative analysis. The data describes the two sectors as a whole, and does not focus on any one particular issue. Exhibit 1: Investment grade vs. High-yield Bonds (for the year ended 2015) High-Yield Bonds Investment Grade Bonds Assets Under Management $55.95 billion $43 billion Total US$ withdrawn $11.29 billion $10.32 billion Spread before withdrawal 8.5% 4.5% Spread after withdrawal 9.3% 5.7% Bid-ask spread in bps (measured in $price for high-14 16 yield bonds and determined an equivalence in bps) After gathering this data, Alexander also made the following observations about the US fixed-income market: Observation 1: “Heterogeneity in market views and assumptions has increased significantly. Over the past few years, individual as well as institutional investors have shown varying interest in fixed-income issuers.” Observation 2: “Total assets under management, of both high yield and investment grade bonds, decreased reasonably over the same time period.” Observation 3: “The balance sheet size of any one particular issue on dealers’ balance sheets decreased considerably.” Observation 4: “Risk-averseness amongst market makers decreased.” In addition to the US fixed-income market, Alexander is also aware about the benefits of including emerging market bonds to a US bond portfolio. For this, he is considering three emerging markets. He has accumulated some preliminary information about the structure of their credit markets using data of their respective popular fixed-income indices. Exhibit 2 expresses these details. Exhibit 2: Emerging Market Data Market A Market B Market C % of government ownership of bond 55% 23% 65% issuers Highest % of bonds in the index w.r.t BBB BB CCC credit rating Increase in supply of corporate bonds High Low High Average interest rates 4.0% 7.0% 9.0% As a continuation to the data gathered, Alexander also jotted down the following expectations: Expectation 1: The market will be bullish in all three countries. While Alexander is concerned about the performance of these markets, and the risks involved, he is somewhat at ease with investing in the US market because he believes that interest rate volatility will remain low in the coming future. To offset the risks taken in international bonds, Alexander wants to invest locally such, that liquidity is high and default risk is low. 31. The most prominent drawback of the analytical approach used by Alexander is that: A. a sizable portion of credit returns may not be identified. B. A semi-strong form efficient market would erode any competitive advantage. C. The effect of financial indicators on security prices will be difficult to measure. 32. Based on the data given in Exhibit 1, which sector of the fixed-income market appears to be more liquid? A. High-Yield. B. Investment Grade. C. Either high-yield or investment grade. 33. Which of the following observations made by Alexander are most likely to indicate an increase in liquidity in the fixed-income market? A. Observations 1 and 4 only. B. Observation 2, 3 and 4 only. C. Observations 1, 3 and 4 only. 34. Assuming an unhedged position, using the data in Exhibit 2, the most attractive investment for a US investor will be: A. corporate bonds in Market C. B. Investment-grade bonds in Market A and investment-grade bonds in Market B. C. Investment-grade bonds in Market C and corporate bonds in Market A. 35. Assuming all other factors are the same, currency risk will be highest for: A. Market A. B. Market B. C. Market C. 36. In the US market, the most appropriate investment given Alexander’s expectations will be: A. Corporate bonds. B. Agency MBS. C. Investment grade bonds.