Dave and Marlene Carter live in the Boston area, where Dave has a successful ort

Question

Dave and Marlene Carter live in the Boston area, where Dave has a successful orthodontics practice. Dave and Marlene have built up a sizable investment portfolio and have always had a major potion 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 it is now 2010 and Marlene is currently evaluating two investment decisions; one involves an addition to their portfolio, the other a revision to it. The Carters' first investment decision involved a short-term trading opportunity. In particular, 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 two years the promised yield of the issue should drop to 8%. The second is a bond swap. The Carters hold some Beta corporation 7%, 2023 bonds that are currently priced at $785. They want to improve both current income and yield-to-maturity, and are considering one of three issues as a possible swap candidate: (a) Dental Floss, Inc. 7.5%, 2035, currently priced at $780; (b) Root Canal Products of America, 6.5%, 2023, selling at $885; and (c) Kansas City Dental Insurance, 8%, 2024, prices at $950. All of the swap candidates are of comparable quality and have comparable issue characterisitcs.

b) Regaurding the bond swap opprtunity:

1. Compute the current yield and the promosed yield (use semianual compunding) for the bond the Carters currenty hold and for wach of the three swap candidates

2. Do any of the three swap candidates provdie better current income and/or current yield than the Beat corporation bonds the Carters now hold? If so, which one(s)?

3. Do you see any reason why marlene should switch from her present bond holding into one of the other three issues? If so, whuch swap candidate would be the best choice? Why?

Explanation / Answer

b) 1) The current yield and YTM of the four bonds are calculated and shown in table below:

2) Only Dental Floss is provides better current income. But its YTM is marginally less (by 0.01%).

The other two have lower current yield and YTM.

3) As the objective is to increase current income and capital gains, the change may be made in favor of Dental Floss, which has a higher current yeild and almost equal YTM. But, dental has a very high maturity period of 25 years as against the 13 years of Beta Corporation. Bonds with longer maturity have higher interest rate risks.

Current Price yield YTM Beta Corporation 7% 2023 bonds   785 8.92% 9.90% Dental Floss Inc 7.5% 2035 780 9.62% 9.89% Root canal products 6.5% 2023 885 7.34% 7.93% Kansas City Dental Insurance 8% 2024 950 8.42% 8.62% YTM calculations: Beta corporation: YTM is the value of r in the following equation 785 = 1000*pvif(r,26) + 35*pvifa(r,26) using a YTM calculator, yield is 9.90% Dental Floss Inc: YTM is the value of r in the following equation 780 = 1000*pvif(r,50) + 37.5*pvifa(r,50) using a YTM calculator, the yield is 9.89% Root canal products: YTM is the value of r in the following equation 885 = 1000*pvif(r,26) + 32.5*pvifa(r,26) using a YTM calculator, the yield is 7.93% Kansas City: YTM is the value of r in the following equation 950 = 1000*pvif(r,28) + 10*pvifa(r,28) using a YTM calculator, the yield is 8.62%

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