Question

# An investor is considering adding three new securities to his internationally focused

fixed-income

portfolio. The securities under consideration are as follows:

• 1-year U.S. Treasury note (noncallable)

• 10-year BBB/Baa rated corporate bond (callable)

• 10-year mortgage-backed security (MBS) (callable; government-backed collateral)

The investor will invest equally in all three securities being analyzed or will invest in none

of them at this time. He will make the added investment provided that the expected

spread/premium of the equally weighted investment is at least 0.5 percent (50 bps) over

the similar-term Treasury bond. The investor has gathered the following information:

Real risk-free interest rate 1.2%

Current inflation rate 2.2%

Spread of 10-year over 1-year Treasury note 1.0%

Long-term inflation expectation 2.6%

10-yr MBS prepayment risk spread (over 10-year Treasuries)∗ 95 bps

10-yr call risk spread 80 bps

10-yr BBB credit risk spread (over 10-year Treasuries) 90 bps

∗This spread implicitly includes a maturity premium in relation to the 1-year T-note as

well as compensation for prepayment risk.

Using only the information given, address the following problems using the risk premium

approach:

A. Calculate the expected return that an equal-weighted investment in the three securities

could provide.

B. Calculate the expected total risk premium of the three securities, and determine the

investor’s probable course of action.

Finance