Case Scenario:
Dave and Marlene Coates live in the Boston Area, where Dave has a successful orthodontics practice. They have built up a sizable investment portfolio and have always had a major portion of their investment portfolio and have always had a major portion of their investments in fixed-income securities. They adhere to a fairly aggressive investment posture and actively go after both attractive current income and substantial capital gains. Assume that is now 2008 and Marlene is currently evaluating two investment decisions: One involved an addition to their portfolio, the other a revision to it.
The Coates' first investment decision involves a short-term trading opportuinity. Marlene has a chance to buy a 7.5%, 25-year bond that is currently priced at $852 to yield 9%; she feels that in 2 years the promised yield of the issue should drop to 8%.
The second is a bond swap. The Coates hold some Beta Corporation 7%, 2020 bonds that are currently priced at $785. They want to improve both current income and yield-to-maturity, and are considering 1 of 3 issues as a possible swap candidate: (a) Dental Floss, Inc., 7.5%, 2020, currently priced at $780; (b) Root Canal Products of America, 6.5%, 2018, selling at $885; and (c) Kansas City Dental Insurance, 8% 2022, priced at $950. All of the swap candidates are of comparable quality and have comparable issue characteristics.
Q1) Regarding the short-term trading opportunity
a) What basic trading principle is involved in this situation?
b) If Marlene's expectations are correct, what will the price of this bond be in 2 years
c) What is the expected return on this investment?
d) Should this investment be made? Why?
Q2) Regarding the bond swap opportunity
a) Compute the current yield and the promised yield for the bond the Coates currently hold and for each of the 3 swap candidates.
b) Do any of the 3 swap candidates provide better current income and/or current yield than the Beta Corporating bonds the Coates now hold? If so, which one(s)?
c) Do you see any reason why Marlene should switch from her present bond holding into one of the other 3 issues? If so, which swap candidate would be the best choice? Why?