The Following Information Relates to Questions
Celia Deveraux Is

question 6

Multiple Choice

The following information relates to Questions
Celia deveraux is chief investment officer for the topanga investors fund, which invests in equities and fixed income. The clients in the fund are all taxable investors. The fixed-income allocation includes a domestic (US) bond portfolio and an externally managed global bond portfolio.
The domestic bond portfolio has a total return mandate, which specifies a long-term re- turn objective of 25 basis points (bps) over the benchmark index. relative to the benchmark, small deviations in sector weightings are permitted, such risk factors as duration must closely match, and tracking error is expected to be less than 50 bps per year.
The objectives for the domestic bond portfolio include the ability to fund future liabili-ties, protect interest income from short-term inflation, and minimize the correlation with the fund's equity portfolio. The correlation between the fund's domestic bond portfolio and equity
portfolio is currently 0.14. deveraux plans to reduce the fund's equity allocation and increase
the allocation to the domestic bond portfolio. She reviews two possible investment strategies.
Strategy 1: Purchase aaa rated fixed-coupon corporate bonds with a modified duration
of two years and a correlation coefficient with the equity portfolio of −0.15.
Strategy 2: Purchase US government agency floating-coupon bonds with a modified du-
ration of one month and a correlation coefficient with the equity portfolioof −0.10.
deveraux realizes that the fund's return may decrease if the equity allocation of the fund is
reduced. deveraux decides to liquidate $20 million of US treasuries that are currently owned
and to invest the proceeds in the US corporate bond sector. to fulfill this strategy, deveraux
asks dan foster, a newly hired analyst for the fund, to recommend treasuries to sell and cor-porate bonds to purchase.
foster recommends treasuries from the existing portfolio that he believes are overvalued
and will generate capital gains. deveraux asks foster why he chose only overvalued bonds
with capital gains and did not include any bonds with capital losses. foster responds with two
statements.
Statement 1: taxable investors should prioritize selling overvalued bonds and always sell
them before selling bonds that are viewed as fairly valued or undervalued.
Statement 2: taxable investors should never intentionally realize capital losses.
regarding the purchase of corporate bonds, foster collects relevant data, which are pre-sented in exhibit 1. $$\begin{array}{l}\text { EXHIBIT } 1 \text { Selected Data on Three US Corporate Bonds }\\\begin{array} { l c c c } \hline \text { Bond Characteristics } & \text { Bond 1 } & \text { Bond 2 } & \text { Bond 3 } \\\hline \text { Credit quality } & \text { AA } & \text { AA } & \text { A } \\\text { Issue size (\$ millions) } & 100 & 75 & 75 \\\text { Maturity (years) } & 5 & 7 & 7 \\\text { Total issuance outstanding (\$ millions) } & 1,000 & 1,500 & 1,000 \\\text { Months since issuance } & \text { New issue } & 3 & 6 \\\hline\end{array}\end{array}$$
deveraux and foster review the total expected 12-month return (assuming no reinvest-ment income) for the global bond portfolio. Selected financial data are presented in exhibit 2.exhibit 2 Selected data on global bond Portfolio
$$\begin{array} { l c } \text { Notional principal of portfolio (in millions) } & € 200 \\\text { Average bond coupon payment (per } € 100 \text { par value) } & € 2.25 \\\text { Coupon frequency } & \text { Annual } \\\text { Current average bond price } & € 98.45 \\\text { Expected average bond price in one year (assuming an unchanged yield curve) } & € 98.62 \\\text { Average bond convexity } & 22 \\\text { Average bond modified duration } & 5.19 \\\text { Expected average yield and yield spread change } & 0.15 \% \\\text { Expected credit losses } & 0.13 \% \\\text { Expected currency gains ( } € \text { appreciation vs. \$) } & 0.65 \% \\\hline\end{array}$$
deveraux contemplates adding a new manager to the global bond portfolio. She reviews three proposals and determines that each manager uses the same index as its benchmark but pursues a different total return approach, as presented in exhibit 3.
$$\begin{array}{l}\text { EXHIBIT } 3 \text { New Manager Proposals Fixed-Income Portfolio Characteristics }\\\begin{array} { l c c c c } \hline \text { Sector Weights } ( \% ) & \text { Manager A } & \text { Manager B } & \text { Manager C } & \text { Index } \\\hline \text { Government } & 53.5 & 52.5 & 47.8 & 54.1 \\\text { Agency/quasi-agency } & 16.2 & 16.4 & 13.4 & 16.0 \\\text { Corporate } & 20.0 & 22.2 & 25.1 & 19.8 \\\text { MBS } & 10.3 & 8.9 & 13.7 & 10.1 \\\hline \text { Risk and Return Characteristics } & \text { Manager A } & \text { Manager B } & \text { Manager C } & \text { Index } \\\hline \text { Average maturity (years) } & 7.63 & 7.84 & 8.55 & 7.56 \\\text { Modified duration (years) } & 5.23 & 5.25 & 6.16 & 5.22 \\\text { Average yield (\%) } & 1.98 & 2.08 & 2.12 & 1.99 \\\text { Turnover (\%) } & 207 & 220 & 290 & 205 \\\hline\end{array}\end{array}$$
-based on exhibit 1, which bond most likely has the highest liquidity premium?

• A) bond 1
• B) bond 2
• C) bond 3

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