Description
Background
You have been working as the chief financial planner for a large company based in Melbourne. Your clients include individuals, government, and private organizations. One of your clients, Peter Silva is 30, is married and has a 5-year-old son. He is employed as a schoolteacher and has recently inherited $600,000 from his father who recently passed away. Peter currently has a balance of a loan amounting to $100,000 to be paid off after 20 years. The current interest rate on this loan is 5%. Although young, unlike many other investors, Peter does not want to take a lot of risk by investing his inheritance in the stock market due to large losses of value of stocks recently. Peter is interested in investing in corporate bond market. His main goal is to accumulate funds for his child’s university education, for his retirement at the age of 60 pay off the balance on his housing loan
Project Brief
Considering Peter’s goals and his attitude towards risk you have decided to invest in AAA rated bonds. You have selected 30-year coupon bonds, 30-year zero coupon bonds and perpetual bonds for Peter’s bond portfolio. The coupon bonds pay a coupon rate of 7%. A zero-coupon bond is currently selling at $535. The coupon rate on perpetuities is 6%. Peter wants to invest equal amounts in each of the above bond categories after deducting the present value of the loan payable in 20 years from his inheritance. Yield to maturity of coupon bonds is currently 8.5%. The zero-coupon bonds and perpetuities pay coupons annually.
Sensitivity of prices to changes in yields
Peter is interested in knowing how the price of coupon bonds reacts to changes in yield to maturity
Explain to Peter using appropriate measures how the price of coupon bonds and perpetuities will change if yield to maturities increase and decrease by 1%, 2%, 3%.
Rebalancing
Rebalancing at a constant interest rate: If the interest rate remains at the same level, how much does Peter have in each of the bonds after one year, two years and three years?
Rebalancing at a higher interest rate: If the interest rate increases by 1%, how much does Peter have in each of the bonds after one year, two years and three years?
Rebalancing at a lower interest rate: If the interest rate decreases by 1%, how much does Peter have in each of the bonds after one year, two years and three years?
