Overview of Fixed-Income Portfolio Management

Correct Answer: Strategy 1, which involves selling some BBB-rated corporate bonds and replacing them with A-rated corporate bonds while slightly reducing the duration to 6.5 years, is the most appropriate strategy for Michael to implement. This strategy directly addresses the requirement to improve the average credit quality of the portfolio to A, while also bringing the duration closer to the lower end of the acceptable range, which may be prudent in the current market environment.

Strategy 1 is the most appropriate choice for Michael to implement. This strategy directly addresses the requirement to improve the average credit quality of the portfolio to A by selling some BBB-rated corporate bonds and replacing them with A-rated corporate bonds. It also brings the duration closer to the lower end of the acceptable range at 6.5 years, which may be prudent given the current market environment. Strategy 2, while bringing the average credit quality to A, does not address the potential credit risk associated with maintaining the high allocation to BBB-rated bonds. It also fails to consider the potential benefits of reducing the portfolio's duration in the current market environment. The third strategy mentioned, although not presented as a formal option, would improve the credit quality and provide a balance between credit risk and interest rate risk. However, it does not take advantage of the opportunity to reduce the duration, which may be beneficial in the current market environment.

Correct Answer: Lisa should implement Strategy 1, which involves increasing the allocation to A-rated corporate bonds while maintaining the same duration. This strategy aligns with the insurance company's investment policy by improving the average credit rating to the required A level and preserving the target duration within the 5-7 year range. Strategy 1 also offers the potential for higher yields through increased exposure to high-quality corporate bonds, which can enhance the portfolio's risk-adjusted returns in the current market environment.

The best strategy for Lisa to implement is Strategy 1, which involves increasing the allocation to A-rated corporate bonds while maintaining the same duration. This approach aligns with the insurance company's investment policy in several ways: 1. It improves the average credit rating of the portfolio to the required A level, addressing the current misalignment with the policy. 2. It preserves the target duration within the specified 5-7 year range, ensuring compliance with the policy's duration requirements. 3. It offers the potential for higher yields through increased exposure to high-quality corporate bonds, which can enhance the portfolio's risk-adjusted returns in the current market environment. Strategy 2 is less suitable because it extends the portfolio's duration beyond the upper limit specified in the investment policy and fails to address the need to improve the average credit rating. Maintaining the current portfolio allocation is also not the most effective approach, as it does not address the misalignment between the portfolio's credit quality and the required A rating, and it misses the opportunity to optimize performance within the given constraints.

Correct Answer: Daniel should maintain the current portfolio allocation and duration, as it aligns with the client's moderate risk profile and objectives of generating steady income and preserving capital. Increasing exposure to high-yield bonds or extending duration may introduce additional risks that do not suit the client's profile.

The best answer is to maintain the current portfolio allocation and duration. This aligns with the client's moderate risk profile and objectives of generating steady income and preserving capital. Increasing exposure to high-yield bonds (Strategy A) introduces additional credit risk that may not suit the client's moderate risk profile. While the higher coupons of high-yield bonds could enhance income, the potential for default and price volatility could jeopardize capital preservation. Extending the portfolio's duration (Strategy B) exposes the portfolio to greater interest rate risk. Although longer-duration bonds offer higher yields, they are more sensitive to interest rate changes. If interest rates rise, the value of the longer-duration bonds would decline more than shorter-duration bonds, potentially leading to capital losses. Given the client's moderate risk profile and the objective of preserving capital, maintaining the current allocation and duration is the most appropriate strategy. The current mix of government and investment-grade corporate bonds provides a balance of stability and income, while the 5-year duration aligns with the client's risk tolerance.