Business Investments Price of Bonds

Question: Discuss about the Business Investments for Price of Bonds. Answer: Executive Summary The purpose of this paper is to design a portfolio for a High Net Worth Australian individual keeping his requirements in context. The portfolio will be designed doing the appropriate research and with a mix which satisfies all the clients requirements. The risk assessment of the portfolio has been done using proven methods such as standard deviation et all. The first section of this paper deals with the identification of the clients needs so that investment parameters could be defined. In the second section we shall construct the portfolio based on the parameters identified and by analysing various asset classes such as equity, debts, cash, bonds, property etc. Thirdly we will do a risk reward analysis in which we will calculate the absolute and the relative returns. In the last section of the paper we end with appropriate recommendations to the client based on the analysis done. Introduction Portfolio means a group of assets selected such that the risk can be diversified without losing on the returns. An investor seeking to build a portfolio is riddled with a lot of available choices. The choice has to be made based on the risk return characteristics of each individual security. Another contention is also to what weightage of his/her corpus to allocate to what kind of security. (Bodie, et al., 2014) We can summaries the process of portfolio construction into five steps as following: Setting objectives: The first step towards portfolio holding is setting objectives keeping in mind the investment horizon, individuals risk bearing capacity and his required returns. (Keel, 2006) Other factors to be kept in mind is the tax rate, current macro economic environment etc. Defining Policy: Once the objectives have been set, a suitable investment policy must be established. This step involves choosing the right mix of assets based on the portfolio objectives identified. Applying portfolio strategy: Portfolio strategy selection based on how proactively involved the investor wants to be in his investments. The two strategies at the opposite spectrums are active and passive respectively. While an active strategy demands higher participation of the fund manager and the individual the passive strategy allows the investor to have a passive stance. Active strategy involves being sensitive to interest rate changes and returns in investments even over a short period of time and hence changing the asset mix of portfolio based on the prevailing market conditions. Hence an active investor would go for more short term investments and less long term investments. For example, if an active investor has invested in an asset class which has shown a 4% loss rather than waiting for it to recover its price he/she might chose to take a proactive stance on it. Similarly if bond prices fall due to rise in interest rates the active participant would immediately sell the bonds while the passive investor whos more concerned about the coupon payments would stay invested. A totally passive strategy usually involves buying securities to match a preselected market index. For example a passive investor would rather invest in equity mutual funds than individual stocks because investing in individual stocks would require active involvement. Passive strategies rely more heavily on diversification to reduce risk. Rather than outperformance risk aversion is the desired attribute of the portfolio. In practice, many active funds are managed somewhere between the active and passive extremes, the core holdings of the fund being passively managed and the balance being actively managed by appointed fund managers.(Morgan Stanley, 2010) Asset selections: Once the strategy is decided, the next stop involves picking up assets individual assets in which to invest and how much to invest. For this purpose the portfolio might employ an well laid down process known as investment process. Again based on portfolio strategy asset selections would be done. Performance assessments: In order to study the performance of portfolio the performance can be reviewed at periodic intervals. For example for investment in equities the benchmark can be the SP/ASX 200 index. Setting Objectives The given individual is 58, has a corpus of 1 billion AUD. He wants his corpus to grow at CPI+2% plus annum and wants to take out 5 million AUD each year from his portfolio to pursue his interests. Since from 2006 to 2016 if we look at the historical CPI data as per the website of Australian Bureau of Statistics the growth from March 2016 to June 2016 has been 28% which is a compounded growth of approximately 2.5% year over the given 10 periods. (RBA, 2006)Since we too are looking at an investment horizon of 10 years we too can stick with same values for CPI especially considering the fact that of late Australian economy has been stable and key benchmarks such as the OCR, inflation, growth projections, AUD vs USD all have been more or less trading at very low volatility. The RBA too through the application of various mechanisms too intend to keep it that way. Hence we would need a growth of 5% post-tax on his corpus to satisfy all his requirements which are as follows: A drawing of 5 million annually. A growth of 4.5% on the initial capital invested. Considering the fact that he is in his late 50s and a moderately conservative investor we will try to construct a portfolio in such a manner that only does it give him the requisite returns but also is not very risky in nature. Defining Policy and choosing assets The various asset classes that we have taken as part of consideration for inclusion in the clients portfolio include cash instruments, equities, government bonds, Australian property, foreign equities and Australian fixed interest. To satisfy his requirements we will chose a mix which has all of this in the mix and gives a return in sync with the clients needs. Since the individuals portfolio strategy would be passive aggressive we stay out of complicated financial products like derivatives and commodity indexes. The table below summarises the returns on various asset classes described. Security Type Expected Return Pre tax Certificate of Deposits 3.2% 2-year bonds 3.25% 10-year bonds 4.25% Foreign Equities 10% Australian Equities 5% Property 9.5% The returns on Certificate of deposits has been taken from the site of Australia and Newels bank which states that for an investment of more than 50,000 AUD the rate of return is 3.2%, interest paid annually. The rate of return on Government bonds have been taken from Bloomberg. (Bloomberg, 2016) Long term bonds have a higher return than short term bonds because with an increase in time the risk increases for which the investors seek a premium.(AAII, 2008) Australian equities historic return has been 5%. (Damodaran, 2016)Through our own analysis we have also computed it to be similar. If we compare the SP/ASX 200 index over the 5-year period, we see that the index has climbed to 5433 FROM 4296.5 which depicts an annual growth of 5%. The data is as per the website of Australian Stock Exchange(ASX). Since we have already decided that we would have a passive stance our investment strategy would be to invest in an equity mutual fund with a reputable fund manager like Teradata or McQuarries which have consistently been giving higher than market returns. Even the portion in equities would be further diversified into 2-3 different funds such as small cap and mid cap funds. The rate of return on foreign equities especially those in emerging economies such as Indonesia and India has been found to be 10%.(Fair, 2016) The rate of return on investments in property has been found to be 9.5% over the last 20 years. If we look at short term returns have been even more lucrative but since we are looking at an investment horizon of 10 years we go with this figure.(ANZ, 2016) Portfolio strategy For the individual our portfolio strategy would be a mix of passive and aggressive with more affinity towards passive since he is already into late 50s and would rather pursue his charitable and artistic interest than being bothered about on a daily basis about his investments. Another factor why we opt for this strategy is because the minimum period for which he stays invested is given as 10 years.Keeping his strategy in mind the assets would be chosen accordingly. Asset Selection Since the individual is under the taxation slab of income of more than 180,001 AUD as per ATO hence effectively his income from his investments would be taxed at approximately 45%. Hence the effective returns that he requires on his portfolio would be 7.25%. We decide that 5 million AUD that the investor requires for his expenses and interests should never stop as a result of market and portfolio volatility and hence we would invest a part of his corpus such that 5 million AUD returns would be guaranteed irrespective of market and economic conditions. For that purpose, we would invest a portion of corpus in a risk free asset so that the 5 million AUD return is guaranteed at all times. Now an example of risk free asset would be government 2 year bonds and certificate of deposits in commercial banks. (Ernst and Young, 2015)Hence 10% of his corpus has been invested accordingly. Similarly keeping in mind his return requirements the rest of his corpus allocation has done. The table below summarises the allocation of the individuals corpus security wise. Security Type Expected Return Weight Weighted Average Return Certificate of Deposits 3.2% 5% 0.16% 2 year bonds 3.25% 5% 0.1625% 10 year bonds 4.25% 10% 0.425% Foreign Equities 10% 25% 2.5% Australian Equities 5% 25% 1.25% Property 9% 30% 2.7% Total 100% 7.1975% Performance Assessment The returns that have been calculated are base case which can be expected 80% of the times and hence we can break the returns on our portfolio scenario wise. Scenario Probability Expected Return Worst 0.1 8.4% Base 0.8 7.2% Worst 0.1 6% Hence we calculate portfolio measures such as standard deviation and variance. Calculations have been done on a spreadsheet and the results are summarised in the table below. Measure Value Variance 0.0648 Standard Deviation 25.46% Variance is varianceis theexpectationof the squared deviation of arandom variablefrom itsmean, and it informally measures how far a set of (random) numbers are spread out from their mean. Standard deviation is a measure of how much members of group differ from the mean value.(New York University, 2013) It is obtained by taking the square root of variance. Recommendations While it is understood that the individual wants to leave an enjoyable peaceful retired life pursuing charities and interests it would augur well for him and his investments as well as his family if he would take an active interest in his portfolios performance. That can be done by periodic reviews of his portfolio performance as well as being updated about the macro and micro economic environment that impacts his portfolios performance. It would also be good if he keeps himself updated about new financial products and how he wants to change his investments depending on if his requirements of portfolio performance change. Conclusion Keeping in mind the individuals requirements and profile the portfolio has been constructed using the tried and tested principles of diversification and risk aversion. The selection has been done such that the fund managers do maximum work and the individual can be at relative peace regarding his investments. Through various analysis varied the assessment of his portfolio has been done which has been satisfactory at various levels. References AAII, 2008. How Interest Rate Changes Affect the Price of Bonds. AAII. ANZ, 2016. ANZ. [Online] Available at: https://www.wealth.anz.com/investments/property-investment [Accessed 28 September 2016]. Bloomberg, 2016. Australian Rates Bonds. [Online] Available at: https://www.bloomberg.com/markets/rates-bonds/government-bonds/australia [Accessed 26 September 2016]. Bodie, Kane Marcus, 2014. Investments. s.l.:McGraw Hill. Damodaran, A., 2016. Default Spreads and Risk Premiums, New York: Stern. Ernst and Young, 2015. Estimating risk-free rates for valuation, s.l.: Ernst and Young. Fair, R., 2016. Risk Aversion and Stock Prices, s.l.: s.n. Keel, S. T., 2006. Optimal Portfolio Construction, Zurich: SWISS FEDERAL INSTITUTE OF TECHNOLOGY ZURICH. Morgan Stanley, 2010. The Essentials of Portfolio Construction, New York: Morgan Stanley. New York University, 2013. Standard Deviations. In: New York: New York University. RBA, 2006. The Structure of the Australian Financial System, s.l.: RBA.