Case Studies on Investment
Instruments and Strategies
Case Study 1: Government Bonds vs Corporate Bonds
Scenario:
An investor, John, is looking to diversify his portfolio and is considering investing in either
government bonds or corporate bonds. He has $50,000 to invest and is considering a 10-
year investment horizon. John is currently employed at a tech company, and he has a
moderate risk tolerance. He is evaluating two bond options:
- Option A: A U.S. Treasury Bond with a 10-year maturity offering a 3% annual coupon rate.
- Option B: A Corporate Bond issued by a technology firm offering a 6% annual coupon rate
but with a lower credit rating (BB).
Objective:
John is looking for a balance between safety and return. He wants to determine which bond
would suit his investment goals, considering both risk and return.
Solution
1. Government Bonds (Option A):
o Risk: Treasury bonds are backed by the U.S. government, making them
among the safest investments available. They are essentially risk-free in
terms of default.
o Return: The 3% coupon rate provides a fixed income, which is lower than
corporate bonds, but it compensates for the low risk involved.
o Tax Advantage: Interest from U.S. Treasury bonds is exempt from state and
local taxes, which may be beneficial depending on John’s location.
2. Corporate Bonds (Option B):
o Risk: Corporate bonds with a BB credit rating are considered high-risk or
junk bonds. There’s a higher chance of the issuing company defaulting
compared to government bonds.
o Return: The 6% coupon rate offers a higher return compared to the
government bond, but it comes with the additional risk of the issuer’s
financial stability.
o Tax Consideration: Interest income from corporate bonds is subject to
federal, state, and local taxes.
3. Recommendation:
o If John prioritizes safety and guaranteed returns, the U.S. Treasury bond
(Option A) is the better choice, given its low risk.
o If John is comfortable with moderate risk and wants to pursue a higher
return, the Corporate Bond (Option B) could offer more potential income
but requires careful monitoring of the issuing company's financial health.
Case Study 2: Impact of Inflation on Fixed Income Investments
Scenario:
Maria is a conservative investor who has invested in Treasury Inflation-Protected Securities
(TIPS) for the past 5 years. She has noticed that the current inflation rate is rising to 5%,
and she is concerned about how inflation will affect her investment’s performance.
Objective:
Maria wants to understand how inflation impacts her TIPS investment and whether she
should adjust her portfolio strategy
Solution:
1. Understanding TIPS:
o TIPS are designed to protect against inflation. The principal value of TIPS
is adjusted with inflation, meaning if inflation rises, the value of the TIPS
increases, and the interest payments will be based on this higher principal.
o Example: If Maria’s TIPS originally had a principal of $10,000 and
inflation rises by 5%, the new principal would increase to $10,500. If her
TIPS bond pays a 3% coupon rate, the interest payment would be based on
the new principal value of $10,500, providing her with $315 instead of
$300.
2. Impact of Inflation on Fixed Income Investments:
o Non-inflation-protected bonds (such as traditional Treasury bonds or
corporate bonds) lose value in real terms as inflation rises because their
fixed interest payments do not adjust with inflation.
o For Maria’s TIPS, the principal adjustment and inflation-adjusted
coupon payments ensure that her investment maintains its purchasing
power.
3. Recommendation:
o TIPS provide a strong defense against inflation, so Maria doesn’t need to
worry about her investment losing value in real terms due to inflation.
o If she is concerned about inflation exceeding the fixed coupon rate (which
might still leave her with a lower real return), Maria could consider
diversifying into inflation-linked corporate bonds or equity
investments for better long-term growth potential, though at higher risk.
Case Study 3: The Importance of Diversification in Portfolio Construction
Scenario:
James is an individual investor with a long-term investment horizon. He currently holds an
entirely stock-based portfolio consisting of shares from tech companies. The value of his
portfolio has been growing steadily, but he’s worried about the volatility in the tech sector
and is looking for ways to reduce risk.
Objective:
James wants to understand how diversification could benefit his portfolio and which assets
he could add to reduce risk while still maintaining potential for growth.
