Price Risk

The Ravensdale Foundation must pay a fixed grant of $500,000 at the end of each of the next eight years. Its adviser buys a set of high-grade zero coupon Treasury securities structured so that exactly $500,000 matures in each of those eight years. This approach is best described as:

1. A.A barbell strategy, because the maturities are concentrated at the short and long ends of the yield curve.Incorrect. A barbell deliberately avoids the middle maturities. These maturities are spread evenly across all eight years.
2. B.Cash flow matching, or a dedicated portfolio, which removes both price risk and reinvestment risk because each obligation is funded by a security maturing when it is due.Correct. Matching maturity amounts and dates to known liabilities is the definition of cash flow matching.
3. C.Immunization, which works by keeping the portfolio duration equal to the duration of the liabilities and rebalancing as rates change.Incorrect. That describes immunization, a different technique. No duration matching or rebalancing is being done here.
4. D.A bond ladder designed to average the reinvestment rate over the eight-year period.Incorrect. A ladder reinvests each maturity to smooth reinvestment rates. Here every maturity is spent on a grant, so nothing is reinvested.

Why: Cash flow matching, also called a dedicated portfolio, funds each known future obligation with a security that matures on the date the money is needed and in the amount needed. Because nothing must be sold before maturity, price risk is irrelevant, and because zero coupon bonds pay no interim interest, there is nothing to reinvest, so reinvestment risk is eliminated as well. The cost of that certainty is flexibility and, usually, a somewhat lower expected return than an actively managed alternative.

Client Anwar Haddad is comparing a publicly traded business development company (BDC) currently yielding 9.5% with a high-yield bond mutual fund yielding 6.8%. He asks his adviser why he should not simply take the higher yield. Which response is most accurate?

1. A.BDC distributions are exempt from federal income tax, which is why the stated yield exceeds that of the taxable mutual fund.Incorrect. BDC distributions are taxable. Only municipal issuers generate federally tax-exempt interest.
2. B.A BDC is a closed-end fund that must redeem shares at net asset value on demand, so its liquidity is comparable to the mutual fund.Incorrect. Redemption at NAV on demand is the defining feature of an OPEN-end fund. Listed BDC shares are sold in the market.
3. C.Because a BDC is regulated under the Investment Company Act of 1940, it is prohibited from borrowing, so the higher yield comes purely from superior security selection.Incorrect. BDCs are expressly permitted to use leverage, and that leverage is a major source of both the yield and the risk.
4. D.A BDC lends to and invests in small private companies, typically employs leverage, and trades at a market price that can differ materially from NAV, so the extra yield compensates for materially greater credit, leverage and price risk.Correct. Private credit exposure, permitted leverage and exchange pricing away from NAV together explain and justify the higher yield.

Why: A business development company is a closed-end investment company that lends to and takes equity stakes in small and mid-sized private U.S. companies. Three features explain the yield gap. Its borrowers are private, unrated and often highly leveraged, so credit risk is greater than in a diversified high-yield bond portfolio. BDCs are permitted to borrow, and that leverage magnifies both income and losses. Finally, because a listed BDC trades on an exchange rather than redeeming at net asset value, its share price can sit at a large premium or discount to NAV, adding price risk the mutual fund does not have.