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