As a hedge fund specializing in locating attractively priced fixed-income instruments, Millennium Cerberus Fund is now reviewing its overall bond allocation strategy following the recent “liquidity squeeze” in the financial markets.
a)Consider three classes of traditional fixed-income vehicles: Treasury bonds, high-grade corporate bonds, and low-grade corporate bonds. In “normal” market conditions, would you expect the liquidity of each of these bond classes to be the same? What would you expect to happen to the liquidity of these bond classes during a credit crisis, such as the one we experienced in 2008?
b)As an analyst for the fund, you note that the correlation of the rate of return between Treasury bills and high-grade corporate bonds is high (0.95), whereas the correlation between Treasury bills and high-yield (i.e., junk) bonds is relatively low (0.52). What are the reasons for the difference in correlations? How would such a disparity affect your bond portfolio allocation?
c)“The duration of junk bonds is typically shorter than that of high-grade corporate bonds.” Briefly defend or refute the validity of this statement and support your position.
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Response should be about 300 words long or more