An investor is considering adding three new securities to his internationally focused fixedincome portfolio. The securities under consideration are as follows:
• 1-year U.S. Treasury note (non-callable)
• 10-year BBB/Baa rated corporate bond (callable)
• 10-year Mortgage-Backed Security (MBS) (callable; government-backed collateral)
The investor will 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 over the similar-term Treasury bond. The
investor has gathered the following information:







Real risk-free interest rate 1.2%
Current inflation rate 2.2%
Spread of 10-year over 1-year corporate bond 1.0%
Long-term inflation expectation 2.6%
10-yr MBS prepayment risk spread (over 10-year Treasuries)* - 0.95%
10-yr BBB call risk spread 0.80%
10-yr BBB credit risk spread (over 10-year Treasuries) 0.90%
∗This spread implicitly includes a maturity premium in relation to the 1-year T-note as well as
compensation for prepayment risk.
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.
Answer:
A.
Real
RiskFree
Rate
1-year
10-year
10-year
U.S. Tnote
corp.
bond
MBS
Expected
Inflation
+
Expected
FixedIncome
Return
Spreads
or
Premiums
1.20%
+
2.60%
+
0% =
3.80%
1.20%
1.20%
+
+
4.30%
2.60%
+
+
1.00% =
0.95% =
6.50%
4.75%
Average
5.02%
B. The average spread at issue is [0 + (0.8% + 0.9%) + 0.95%]/3 = 0.88%.
As 0.88 percent exceeds 0.5 percent, the investor will take an equally weighted position in the
three securities.
We exclude the 1 percent maturity premium for the 10-year corporate as the comparable is a
10-year T-bond also bearing the 1 percent maturity premium.
2. Seth Bildownes is an analyst who has prepared forecasts regarding the current capital market
environment. He recently gave his presentation to the managing directors of his firm. Excerpts
of his presentation follow:
‘‘Noting that year-end holiday sales have been weak over the past several years, I believe that
current expectations should be likewise muted. In fact, just last week, I had an occasion to visit
Harrods and noticed that the number of shoppers seemed quite low.
The last time I saw a retail establishment with so little pedestrian traffic at the beginning of
December was in 1990, and that coincided with one of the worst holiday sales periods in the
past 50 years. Thus, there will be no overall year-over-year retail sales growth this holiday
season.’’
A. Identify any psychological traps that may be interfering with the creation of Bildownes’s
forecasts.
B. Recommend a way to mitigate the bias caused by any trap identified in Part A.