Fixed Income

Correct Answer: Reduce the portfolio's exposure to the bond by selling a portion of the holding and reallocating the proceeds to higher-quality credits with more stable financial metrics.

The most appropriate action for Elizabeth is to reduce the portfolio's exposure to the bond by selling a portion of the holding and reallocating the proceeds to higher-quality credits with more stable financial metrics. The bond's credit risk has increased significantly, as evidenced by the company's deteriorating financial ratios (debt-to-EBITDA ratio increasing from 3.2 to 4.6 and interest coverage ratio declining from 3.5 to 2.2). This indicates that the company's ability to service its debt has weakened. Additionally, the company's plans to expand its store network and invest in new product lines could further strain its financial position, increasing the risk of default. While the bond offers an attractive yield of 6.0%, which is 280 basis points above the benchmark Treasury yield, the increased credit risk may not be adequately compensated for by the higher yield. As a fixed-income portfolio manager, Elizabeth's primary objective should be to manage credit risk and protect the portfolio's capital. Maintaining the current position or increasing the allocation to the bond would expose the portfolio to unnecessary credit risk, given the company's deteriorating financial metrics and ambitious expansion plans. Therefore, reducing exposure to the bond and reallocating the proceeds to higher-quality credits is the most prudent approach for Elizabeth to manage the portfolio's credit risk.

Correct Answer: Reduce the position in the bond or sell it entirely, as the deteriorating credit metrics and the potential impact of the acquisition on the issuer's financial health increase the credit risk.

The most appropriate action for Andrea is to reduce the position in the bond or sell it entirely. The deteriorating credit metrics, such as the increase in the debt-to-EBITDA ratio from 2.5 to 3.2 and the decline in the interest coverage ratio from 5.0 to 3.8, indicate that the issuer's financial health is weakening. This increases the credit risk associated with the bond. Additionally, the company's plans to acquire a smaller competitor could further strain its financial position, as acquisitions often involve taking on additional debt or using cash reserves. This could exacerbate the credit risk concerns. While the yield spread of 150 basis points above the benchmark Treasury yield may seem attractive, it may not adequately compensate for the increased credit risk. As a fixed-income portfolio manager, Andrea should prioritize the preservation of capital and minimize exposure to bonds with deteriorating credit quality. Increasing the position in the bond would be imprudent given the issuer's weakening financial position and the uncertainty surrounding the impact of the acquisition on its credit profile. Although the acquisition could lead to synergies and improved performance in the long run, the near-term credit risks outweigh the potential benefits.

Correct Answer: Reduce the portfolio's exposure to the bond by trimming the position, considering the deteriorating credit metrics and the potential for further financial strain due to the company's modernization plans.

The most appropriate action for Adam is to reduce the portfolio's exposure to the bond by trimming the position. This decision is based on several factors that indicate a deterioration in the company's credit quality and an increase in credit risk: 1. The company's debt-to-equity ratio has increased from 2.0 to 3.2 over the past year, suggesting that the company has taken on more debt relative to its equity, which increases its financial leverage and credit risk. 2. The interest coverage ratio has declined from 4.0 to 2.6, indicating that the company's ability to service its debt obligations using its operating income has weakened. This could lead to a higher probability of default. 3. The company's plans to modernize its network infrastructure could lead to increased capital expenditures and higher debt levels, further straining its financial position and credit metrics. Although the bond offers a higher yield compared to the benchmark Treasury yield, the increased credit risk may not be adequately compensated by the additional yield. Maintaining the current position or increasing the allocation to the bond could expose the portfolio to greater credit risk, especially if the company's financial condition continues to deteriorate or if its modernization plans do not yield the expected benefits. Therefore, reducing the portfolio's exposure to the bond is a prudent risk management strategy that aligns with Adam's responsibility as a fixed-income portfolio manager to protect the portfolio from potential credit losses.