TO 48 RELATE TO FIXED INCOME FAST-TRACK INVESTMENTS (FTI)...
Questions 43 to 48 relate to Fixed Income
Fast-Track Investments (FTI), CFA, Case Scenario
Katie Lin, CFA, has been hired by Fast-Track Investments (FTI), a fund management
firm in USA, as a capital advisor and strategic funds planner for FTI’s major clients. As
his first task on job, Lin addresses the strategic asset allocation of Ed Freeman, a private
client with $75,000 in surplus funds invested in equity, fixed-income and real estate.
Freeman has taken several loans to fund his education and business development, which
he needs to pay off in three years’ time. Although he has considerable capital that could
be used to pay off his liabilities, Freeman wants Lin to construct a laddered strategy for
his fixed-income allocation to aid in the retirement of his debt obligations. Lin states that
Freeman could benefit even if his fixed-income allocation is structured as a barbell
portfolio, instead of a laddered one. However, still being fixated on pursuing the laddered
approach, Freeman elaborates further on the basic objectives he wishes to achieve, as
listed below:
Objective 1: Minimum risk of capital losses, especially when liquidating individual
holdings to meet cash outflows.
Objective 2: A greater diversification of default risk so as to minimize credit losses.
Objective 3: Greater liquidity with lower administrative cost.
Objective 4: Greater diversification of interest rate risk, especially of twists and
curvature changes.
Freeman also states that he would like to consider options other than direct investing in
fixed-income securities in order to seek exposure to a passive fixed-income index. Lin
gives him several options including investing indirectly through a mutual fund, an
exchange-traded fund, or an index-based total return swap. While offering an elaboration
of each of these options, Lin makes the following comments regarding their respective
benefits:
Mutual Fund: “Mutual fund holders can redeem their holdings at the fund’s NAV. In
addition, monthly interest payments are known to investors and fixed, which reduces
Exchange Traded Fund: “ETFs are much more liquid than mutual funds. Their NPV is
usually very close to the value of the underlying securities as arbitrage aims to eliminate
the spread.”
Total return swap: “A lower cost alternative to the other two, with a lower big-ask
spread. In addition, these more advantageous funding terms are achieved along with the
conservation of confidentiality.”
After analyzing the alternatives available for investing in the debt market, Lin sheds light
on the importance of selecting an appropriate benchmark that closely fulfills Freeman’s
objectives. Lin shortlists the benchmarks listed in Exhibit 1.
Exhibit 1: Benchmark Candidates
Global Fixed-Income
Market Global
Broad US-Based
Weighting scheme
Value-weighted
GDP-weighted
GDP-weighted
Duration
3.17
3.18
5.50
Refinancing
To longer maturity
bonds
None
None
Average credit
quality
AAA
AA
AAA
*Levered investments by issuers in the energy sector increased considerably over the past
few years
If a passive investment in a bond index is chosen, Freeman wants to make sure that his
liabilities are properly accounted for.
Freeman is also considering the addition of collateralized debt obligations to his asset
allocation. Lin suggests that since the economy is overheating and reaching its peak,
spreads of CDO tranches have widened in fear of credit losses and defaults in the future.
He further states that as correlations of expected defaults on the collateral in CDOs are
rapidly rising and reaching a perfect positive value, CDOs would not be suitable, given
that meeting liabilities is of top priority.
43. Compared to a barbell portfolio, a laddered portfolio is least likely superior with
regards to:
A.
convexity.
B.
Liquidity.
C.
Cash flow reinvestment risk.
44. Which of the following objectives is least likely to be achieved using a laddered
portfolio relative to a mutual fund?
A.
Objective 1.
B.
Objective 2.
C.
Objective 3.
45. An ETF-based laddered portfolio will most likely be a superior alternative to a
mutual fund to meet:
A.
Objectives 1, 2 and 3.
B.
Objectives 1, 2, and 4.
C.
Objectives 1, 3 and 4.
46. Lin is most accurate with respect to the benefits of the:
A.
ETF.
B.
Mutual fund.
C.
Total return swap.
47. The most appropriate benchmark index for Freeman is likely the:
A.
Global fixed-income.
B.
Market Global.
C.
Broad US-based.
48. With regards to CDOs, assuming that defaults did not occur as Lin predicted,
which of the following positions would most likely have profited the most?
A.
Selling the senior tranche and buying the mezzanine tranche of a CDO.
B.
Selling investment grade corporates and buying the senior tranche of a
CDO.
C.
Buying investment grade corporates and selling the mezzanine tranche of
a CDO.