Suppose that you manage a retirement fund that must pay a level stream of guaran

Question

Suppose that you manage a retirement fund that must pay a level stream of guaranteed annual benefit payments over the next thirty years. Your goal is meet these obligations with minimum risk, at minimum cost today. Explain the benefits and disadvantages of the following investment strategies.

a.) Invest in a portfolio of 30-year Treasury bonds with a coupon equal to the par yield, i.e., Treasury bonds selling for their par value.

b.) Invest in equal face value amounts of Treasury zero’s maturing in years one through thirty.

c.) Invest in equal portfolio weights (present value) of Treasury zero’s maturing in years one through thirty.

d.) Invest in a duration-matched portfolio of Treasury bonds of various coupons and maturities.

e.) Invest in a duration- and convexity-matched portfolio of Treasury bonds of various coupons and maturities.

f.) Invest in a 50%/50% mixture of Treasury bonds and corporate bonds which have higher yields, while matching the overall duration to the duration of your liabilities.

Explanation / Answer

a) Benefits: Its Safe and backed by the Government. It has the liquidity, marketability, low risk, regular interest income.

Disadvantages: Interest rate fluctuation, low rate of return, Companies could face unforeseen circumstances that could undermine their ability to generate cash flow. The interest payments – or repayment of principal – associated with a bond depend on an issuer's ability to generate this cash flow. Corporate bonds can provide a reliable stream of income for investors.

b) Benefits: they're sold at a big discount to face value; when they mature, you collect the full amount. Certain period and amount, less capital required. so 1 through 30 means you will get the money regularly / yearly which is equal to face value.

Disadvantages: No Regular interest payment, No opportunity to reinvest the interest at higher yields, If Zeros are in regular account, you need to pay tax on the income whic you have not received yet, Hieghly volatile, When the market's interest rates raise, zero-coupon bond prices drop significantly, resulting in a great loss of capital when the investor sells bonds before its maturity. so in equal face value amount, the amount will be very less as it is not accumulated.

c) Benefit: less risk and regular inflow of funds.

Disadvantage: the amount will be very less as it is not accumulated.

d) Benefit: Diversification of risk. More Return, income on different different time as per the maturity.

Disadvantage: income is not fixed, No yearly income, more records to be kept for all so higher maintenance.

e) Benefit: Duration and convexity allow investors to quantify this uncertainty and are useful tools in the management of fixed-income portfolios.

Disadvantage: Price sensitivity, maturity period can be increased, uncertainity, interest rate fluctuations

f) Benefit: Benefit of both the fields provate and government, Safe and secure because of treasury bonds, higher yield because of corporate bonds. credibility, compensatory for risk and return. if it is matching the overall duration to the duration of your liabilities then the best part is you would have money when you actually have the requirement.

Disadvantage: fluctuations because corporations can have unexpected changes in their business model, environment and management that can impact their sustainability.

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