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 2013 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%, 2026 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%, 2038, currently priced at $780; (b) Root Canal Products of America, 6.5%, 2026, selling at $885; and (c) Kansas City Dental Insurance, 8%, 2027, prices at $950. All of the swap candidates are of comparable quality and have comparable issue characterisitcs.
a) Reguarding the short-term trading opportunity:
1. What baisc trading principle is involved in this situation?
2. If Marlene's expectation are correct, what will the price of this bond be in 2 year?
3. What is the expected return on this investment?
4. Should this investment be made? Why?
b) Regarding the bond swap opportunity:
1. Compute the current yield and the promised yield (use semiannual compounding) for the bond the Carters currently hold and for each of the three swap candidates
2. Do any of the three swap candidates provide 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, which swap candidate would be the best choice? Why?
(Kindly provide all Workings for Each Answer.)