Fixed income task model answer

Question 1 example answer

Apple (Aa1) – Apple is one of the world’s most successful technology companies,
located in the United States. The company designs and manufacturers mobile
phones, computers and media devices as well as providing software related
services. It is one of the world’s four largest companies by market capitalisation and
has been issued an Aa1 rating by Moody’s Investors Service. Due to its strong
business profile, it has an extremely strong interest coverage ratio of almost 18x and
recorded net profits of USD 13.7 billion in 2019.

BHP (A3) – BHP is a global resource company that exports commodities such as
iron ore, coal, copper and uranium. The majority of its operations are Located in
Australia and the Americas. The company employees more than 72,000 people and
is headquartered in Melbourne, Australia. The company currently has an investment
grade A3 rating from Moody’s Investor Service, an interest coverage ratio of 15x and
recorded net profits of USD 8.3 billion in 2019.

Question 2 example answer

For your information, the highest yielding bond is the 2027 BHP bond, which also
has the steepest slope of the three issuers. This means that the longer the maturity
date we receive comparatively more for investing in BHP bonds. As a simple
example we can compare the <2-year bonds (i.e. the left hand side of our chart) to
see that buying BHP versus Apple would only see investors receive an additional 20
basis points of yield, compared to almost 50 basis points at 7 years to maturity.
Furthermore, the slope of the government curve stops rising after 7 years.
Question 3 example answer

My recommendation to the portfolio manager is to buy the BHP 2025 bonds, which
have a yield to maturity of 2.10%.

Firstly, as seen from the yield curve in Question 2, the BHP yield to maturity offers a
higher potential return than the Apple securities. The longer the portfolio manager
can invest, the higher that return becomes. For BHP, the recommendation is to go
longer than three years as there is little additional yield pickup versus Apple for
buying their bonds (i.e. look at the yield differential in the front left hand side of the
chart), which have a shorter maturity date but offer more additional yield the longer
we can invest (i.e. at five years the portfolio manager can receive an additional 40
basis points of yield).

The second reason for this choice is not just related to yield, but that the
fundamentals of BHP look sound. While both companies are strong corporates that
set the industry standard, the fundamentals of BHP are positive. The company has a
strong interest coverage ratio and investment grade rating, meaning that there is little
chance of default in the near term. Given both companies have strong financial
metrics, we have opted to look for the issuer that would provide the highest yield.

Finally, my recommendation is not to go into the highest yielding BHP 2027 bonds,
as I am not as certain of the outlook for the company over the longer term. Rather,
my recommendation is to go with a five-year holding, which will roll into a shorter
maturity date faster than the 7-year bond. Additionally, compared to government
bonds, at this maturity point the BHP bonds offer a substantial pickup in yield.

Question 4 example answer

Yes – in this environment I would change my selection of issuer to Apple, as they are
far less exposed to commodity prices. Given our economist is forecasting falling
commodity prices, this could cause BHP bonds to underperform the market. Given
the internal forecast is for commodity prices to worsen, we should adjust to this
information. Furthermore, because Apple is a business that generates its sales
internationally, it should not be as exposed to a slowdown in the Australian economy,
which would occur if commodity prices fell.

Additionally, the forecast from the economist is for the RBA to cut interest rates. This
typically stimulates demand for consumer goods. This could lead to a pickup in
electronic goods – the sector that Apple operates in. In my view, the outlook for
Apple is likely positive enough to justify giving up the benefit of higher interest rates
that BHP offers.

With this in mind, I recommend the longer dated Apple bonds, such as the 2027s or
2030s. The longer dated bonds offer higher interest rates than the shorter dated
bonds, but also longer durations (which is a bond’s sensitivity to interest rates).
Given longer dated bonds will have greater price increases than short dated bonds,
when interest rates fall, we could also benefit from the RBA cutting rates by investing
in the longer dated maturities.