Foster Capital: Analyzing Prices, Yields, and Returns

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Foster Capital: Analyzing Prices, Yields, and Returns

Thomas Gilbert and Lance Young

September 2013

You've recently been hired as an analyst by a small hedge fund, Foster Capital (FC), to help them analyze future investment opportunities. Up until now, FC has specialized in equities, but they are considering expanding into the fixed income market. Your first major assignment is to analyze two zero-coupon U.S. Treasury securities, also called STRIPS: a 1-year security and a 10-year one, both with $1,000 face values. The real risk-free rate of interest is constant at 2% across all maturities. Inflation expectations from the Cleveland Federal Reserve are given in Table 1. The current market price of the 1-year security is $962.11 and the current market price of the 10-year one is $604.52.

a) What is the shape of the nominal term structure of interest rates? BA 500 – Finance: You can skip this question since it has already been answered in the spreadsheet. Going forward, use the nominal rates as discount rates.

b) Calculate a fair price for each security.

c) What is the fair yield-to-maturity (YTM) of each bond?

d) If you were to buy each security today and hold each to its respective maturity, what would be your annualized rate of return for each security?

e) What is the net present value (NPV) of each security?

f) The associate supervising your work constantly says that buying the higher yielding security is a "superior" investment. Do you agree? Why or why not?

Congratulations, because of your outstanding analysis of the Treasury market, you have just been promoted to associate at FC. Your task now gets harder as you must analyze corporate fixed income securities. Your director is currently looking at two bond issues with 1 year remaining maturities. The first is a AA-rated debenture issued by SRT Industrial, a large, privately held U.S. machine tool manufacturer. The second is a CCC-rated debenture issued as part of the leveraged buyout of YCV Foods, a Pacific Northwest food distribution company. Relevant information about the bonds, including price, coupon rates, and face values can be found in Table 2.

Like most bonds, neither trades on an exchange, but Table 1 includes recent price quotes obtained by FC's broker. Table 2 also includes Standard and Poor's estimates that the bonds will default in the next year. These suggest that SRT has 1% chance of defaulting, but that YCV has around a 30% chance of defaulting. Standard and Poor's suggests that

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should YCV default, bondholders can expect to receive only 40% of the total amount

they are owed, while SRT bondholders can expect to receive 90% of the total amount due

to them.

Finally, you have contacted your former core finance professor at the Foster School, and

he has graciously agreed to help you estimate of the costs of debt for each company.

According to him, for SRT Industrial, because of its minimal risk of default, the nominal

risk-free rate needs to be adjusted by a premium of about 0.40% per annum in order to

obtain the firm's opportunity cost of capital. For YCV Foods, because of its substantially

higher risk of default, the premium adjustment over the nominal risk-free