Question

Need help with qns a, b, d and f. Thank you so much.

Describe the objective and risk profile of a "classic stock-bond” or balanced fund portfolio (5 marks) (b) Appraise the Treasuries bond and note market and the main risks attached to them. (6 marks) Indicate the characteristics of the S&P Index in terms of underlying market, component stocks, weighting methodology. (5 marks) (d) Appraise the components of a stock return and the difference with the return on a bond. (5 marks) Analyse the return performance of the US 60/40 equity/bond portfolio TIOY (Treasuries 10 years) since the global financial crisis of 2008 up to now. (7 marks) (1) Briefly discuss what an inverted yield curve is and what this shape of the yield curve could imply in terms of the future market conditions. (7 marks)

Answer 1

a. The basic portfolio-allocation model of 60% stocks, 40% bonds has stood the test of time and provided generations of investors and financial advisors with a balanced investment approach. The strategy behind the 60-40 rule lies in modern portfolio theory, which prescribes that diversifying asset classes often can provide returns at lower volatility. Otherwise, A balanced fund is another option for intermediate-term investors. Balanced funds, which are often called hybrid funds, own both stocks and bonds. They earn the "balanced" moniker by keeping the balance between the two asset classes pretty steady, usually placing about 60% of their assets in stocks and 40% in bonds.

The investment objective of a Balanced investor is to obtain a balance of security, income and growth with security and income ranking before growth in priority.A Balanced portfolio looks to invest around 50% in growth assets (eg equities and property) and the remainder in defensive assets (eg cash and fixed income). The figure of 50% is a general benchmark; actual allocations over time will vary around this as investment conditions change and investment managers take opportunities to improve returns.

This portfolio suits investors who desire a modest level of capital stability but are willing to accept moderate investment value volatility in return for potential investment performance.Such a portfolio is suitable for investors with a medium term investment time frame. It is important to note that the value of your capital can move up and down over time, particularly in shorter time spans. Hence these investments should be considered with a minimum time frame of 3 years.

Also, Investors who are in between these two camps can opt for a balanced investment strategy. This would consist of mixing elements of the more conservative and aggressive approaches. For example, a balanced portfolio might consist of 25% dividend-paying blue-chip stocks, 25% small capitalization stocks, 25% AAA-rated government bonds, and 25% investment-grade corporate bonds. Although the exact parameters can be fine-tuned in many different ways, most balanced investors will be seeking modest returns on their capital along with a high likelihood of capital preservation.

b. Treasury bills, notes, and bonds are fixed-income investments issued by the U.S. Department of the Treasury. They are the safest investments in the world since the U.S. government guarantees them. This low risk means they have the lowest interest rates of any fixed-income security. Treasury bills, notes, and bonds are also called "Treasurys" or "Treasury bonds" for short. In a word, a U.S. Treasury bond (often called a T-bond) is a fixed-interest debt security issued by the U.S. Treasury Department to raise funds to finance Uncle Sam’s spending requirements. Treasury maturities range from 30 years for a T-bond and from two to 10 years for Treasury notes, or T-notes. Interest payments are paid out twice-annually to bondholders.

Main risks Attached to them are:

1. Inflation

2. Interest Rate Risk

3. Opportunity Costs

4. Interest Rate Risk

5. Supply and Demand

6. Reinvestment Risk

7. Default Risk

8. Market risk & Credit risk

d. The investor’s required rate of return is one of the factors to consider when selecting securities for an investment portfolio. The required rate of return is the minimum rate of return an investor should accept from an investment, in order to compensate him or her for deferring consumption. In other words, an investor invests in an investment today in order to enjoy the benefits and rewards at a later stage.

The components of an investor’s required rate of return that will compensate her for the risk taken are:

• The time value of money during the investment period
• The expected rate of inflation during the investment period
• The risk involved

Other Components of a stock return can be classified as:

1. The Issues 2. Dividends 3. Valuation

f. An inverted yield curve represents a situation in which long-term debt instruments have lower yields than short-term debt instruments of the same credit quality. The yield curve is a graphical representation of yields on similar bonds across a variety of maturities. A normal yield curve slopes upward, reflecting the fact that short-term interest rates are usually lower than long-term rates. That is a result of increased risk premiums for long-term investments. When the yield curve inverts, short-term interest rates become higher than long-term rates. This type of yield curve is the rarest of the three main curve types and is considered to be a predictor of economic recession. Because of the rarity of yield curve inversions, they typically draw attention from all parts of the financial world.

Yields are typically higher on fixed-income securities with longer maturity dates. Higher yields on longer-term securities are a result of the maturity risk premium. All other things being equal, the prices of bonds with longer maturities change more for any given interest rate change. That makes long-term bonds riskier, so investors usually have to be compensated for that risk with higher yields.

The Yield Curve is a graphical representation of the interest rates on debt for a range of maturities. It shows the yield an investor is expecting to earn if he lends his money for a given period of time. The graph displays a bond’s yield on the vertical axis and the time to maturity across the horizontal axis. The curve may take different shapes at different points in the economic cycle, but it is typically upward sloping. The sudden inversion of the US yield curve (10Y-3Mo) on Friday to -3 bp, following the sustained decline in euro area manufacturing sector PMI to 47.3 in March 2019 has deepened fears of a recession in the US. The past four recessions were indeed preceded by flattening or inversion of the yield curve, which indicated a slowdown in consumption growth (1978-80, 1991-92, 1999-2000, 2007-08). However, flattening or inversion of the curve also occurred without leading into a recession in 1985-86, 1994-95, 1997-98 and 2005-06. Thus, there are enough instances in the past where the curve flattening has not resulted in a recession. This implies that the curve inversion is not a good predictor of recession, although it makes the economy susceptible to one if there are external shocks.