A fixed-income portfolio manager at Franken Investments is considering adding a security to his existing portfolio. The bond, issued by KDJ Company, has an option adjusted spread (OAS) equal to 0.23% and a Z-spread equal to 0.15%. The manager is concerned that his portfolio is dominated by callable bonds and will only accept new securities if they contain no call options. Should the portfolio manager add the KDJ bond to his portfolio?
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A. B. C.Explanation
To determine whether the portfolio manager should add the KDJ bond to his portfolio, let's analyze the given information:
Option Adjusted Spread (OAS): The OAS measures the spread over the risk-free rate that compensates investors for assuming the credit risk and prepayment risk associated with a bond. In this case, the OAS is stated as 0.23%.
Z-spread: The Z-spread is the spread over the benchmark yield curve that compensates investors for assuming all risks, including credit risk, prepayment risk, and option risk. The Z-spread is stated as 0.15%.
Given that the portfolio manager is concerned about the dominance of callable bonds in his portfolio, we need to determine if the KDJ bond contains a call option.
To determine if the bond is callable, we can compare the OAS and the Z-spread. If the OAS is higher than the Z-spread, it suggests the presence of a call option. Conversely, if the OAS is lower than the Z-spread, it indicates the absence of a call option.
In this case, the OAS (0.23%) is higher than the Z-spread (0.15%). Therefore, the bond is likely callable, and the negative option cost implied by the higher OAS suggests that it is putable, not callable. Hence, Answer A ("Yes, the negative option cost implies the bond is putable") is the correct choice.
To summarize:
Therefore, the portfolio manager should add the KDJ bond to his portfolio since it does not contribute to the dominance of callable bonds.