DoctorMoon11154
Kris Trejo, who recently retired, has come to you for financial…
Kris Trejo, who recently retired, has come to you for financial help. At the initial consultation, you realized that he is an investor with a very low risk tolerance who wants to increase current income. Trejo has $300,000 invested in certificates of de-posit with maturities of one to three years earning rates of 3 percent. While you believe that such a large amount invested in one type of asset at one financial institution is a decidedly inferior strategy, you also realize that Trejo would not be willing to alter the portfolio in any way that would largely impact on risk.Since he is primarily concerned with income and safety of principal, you believe that initially the best strategy would be to alter the portfolio by substituting quality bonds for a substantial propor-tion of the certificates of deposit. Thus, you suggest that $250,000 be invested in a laddered bond port-folio. Of the $250,000, $25,000 would be invested in triple-A- or double-A-rated bonds with one year to maturity, $25,000 with two years to maturity, and so on until the last $25,000 is invested in bonds with ten years to maturity. Thus, none of the bonds would have a maturity exceeding ten years, none of the bonds would have a rating of less than double A, and each year $25,000 of the bonds’ face amounts would mature.Trejo agreed to the basic strategy but required that all the bonds be federal government obliga-tions. Currently the structure of interest rates is as follows:
Term to Maturity Coupon Rate of Interest
1 4.0%
2 4.0%
3 4.0%
4 5.0%
5 5.0%
6 5.0%
7 6.0%
8 6.0%
9 7.0%
10 7.0%
All the bonds are currently selling at par ($1,000 per $1,000 face amount). Trejo still has doubts concerning the risk of loss of principal, but he likes the fact that additional income can be gen-erated by the bonds with the higher coupons. To help convince him this is an acceptable strategy, an-swer the following questions:
1. If the interest on the CDs was $9,000, what is the increase in income generated by this lad-dered strategy?
2. What is the advantage of investing $25,000 in bonds maturing each year instead of investing the entire $250,000 in the ten-year bonds?
3. How much could Trejo lose of the $250,000 if he follows this strategy and, after one year, inafter one year, inafter one year-terest rates rise across the board by 1 percent (100 basis points)?
4. Would the additional earned interest offset the loss from the rise in interest rates?
5. How much additional loss would be incurred compared to the loss in Question 3 if Trejo in-vests the entire $250,000 in the ten-year bonds and one year later the interest rates rise to 10 percent?
6. What should Trejo do with the $25,000 from the bond that matures after one year if he finds that he does not need the principal?
