Question

a) Describe the objectives of an Investment Policy Statement and how the objectives may vary by investors, use examples where possible. (15 marks)

b) What are the main factors that affect the prices of bonds trading in the secondary market? Give examples of how these factors may have affected prices in the past or may do so in the future.(20 marks)

Answer 1

Answer a. The objectives of an Investment Policy Statement are :

1. It lists the investment goals of the client for example what is the time horizon that the client is investing for i.e. some clients may be investing for short term such as to buy a car or house in next 2-3 years or long term for retirement etc goals.
2. It outlines the general rules & strategies that the client expects the investment manager to follow. For example a client with objectives of high growth for which he is willing to take moderate returns may want his investment manager to chase high growth stocks, frequently altering the portfolio as required. On the other hand a client whose objective is to get a stable, low risk return would like his investment manager to choose time tested portfolio strategies without frequent tinkering to the portfolio structure.
3. It provides criteria about allocation in different types of assets for example how much of the portfolio will be comprised of stocks & how much of bonds. It may further go on to detail the allocation in different stock classes such as technology stocks, financial stocks etc.
4. Risk tolerance of the client is also documented in this statement.
5. Liquidity requirements of the investment are listed. For example in what time duration the client can ask the manager for the investments to be liquidated & get back the liquidated value.
6. It also describes the monitoring and control procedures that will be followed by managers & clients during the course of investment.

Answer b.

The main factors that affect the price of the bonds in the secondary market are:

1. The prevailing risk free rate of interest: Th risk free rate is generally estimated by the yield of government securities like US treasury bonds & T-notes. If risk free rate goes up , the price of most fixed coupon bonds trading in the secondary market would go down.
2. Overall economic outlook: If the investors are optimistic about the economy & have a positive outlook, the risk appetite will be higher & they would be willing to invest in relatively risky bonds. but if their is pessimism prevailing in the investors then they would not be willing to buy risky issues thus leading to fall in prices. For example, in the aftermath of the 2007-08 financial crises,investors were both pessimistic and risk-averse, so most of the bond prices took a big hit & traded at very low levels.
3. Inflation rate: If inflation rate increases, the price of fixed coupon bonds usually falls since the real returns would go down on such bonds. On bonds which have inflation linked coupon rate, the effect of this factor will be very less.
4. Default risk: The higher the bond's risk of default, the lower the bond's price in the secondary market. For example the bond prices of bonds issued by one of India's largest housing finance company, DHFL , started falling in December 2018 when there was perceived risk that it would default on those bonds resulting from DSP BlackRock fund selling DHFL bonds in large quantities.
5. Changes in credit ratings : Changes in ratings of the bonds by rating agencies such as S&P , Fitch & Moody's causes bond prices to respond rather quickly. For example a rating downgrade by Fitch from AA to BBB of a firm's issued bonds would lead to knee jerk drop in the price of the bond in next few market sessions itself. Also it may be noted that bond ratings themselves are based on the criteria that include above listed factors in addition to company or bond specific factors.