Case of Investment

Case of Investment

Decision on 100-year bond:

Pros:

1. Bond with long duration benefits more from decrease of interest rate. So if the interest rate is going to decrease, the 100-year bond can help investors get more profits.
2. The coupon rate of the 100-year bond is lower than the 30-year bond, so the credit risk and default risk of the 100-year bond are lower.

Cons:

1. Compared with 10-year bond and 30-year bond, the 100-year bond has the lowest liquidity because of its long maturity. In the meantime, the 100-year bond is more vulnerable to sudden changes in interest rates and investors have to take a 100-year period bet on Petrobras or government’s credit risk.
2. The price of a long-term bond is more sensitive to interest rate changes than prices of short-term bonds due to the large duration and convexity. So 100-year bond is riskier than the other two bonds.
3. As we know, the increase in interest rate leads to the strong U.S. dollar. Then a decline of oil price attributed to the increasing purchasing power is shown. So when interest rate increases and oil price decreases at the same time, investors will face a severe condition. Because 100-year bond, which has a long duration, is riskier when interest rate increases. Moreover, Petrobras will suffer a decrease of revenue as oil price decline. So in this condition, investors will lose more.

Decision on 10-year bond:

Pros:

1. Compared with the other two bonds, the 10-year bond has the lowest duration and convexity due to its shortest maturity, which means that the price of the 10-year bond is less sensitive to interest rate change. So the interest rate risk the 10-year bond suffers is the lowest among all the three bonds.
2. Because of the shortest maturity, the 10-year bond has the highest liquidity. If investing in the 10-year bond rather than bonds with longer maturities, investors could have more investment opportunities in the same time period, which means investors can take better advantages of their capitals.
3. It is well-known that price of bond will decrease when interest rate increases. Because of the lowest sensitivity to interest rate change, the 10-year bond will suffer less loss than the other two bonds when the interest rate increases.

Cons:

1. Although the 10-year bond could ensure the least loss when interest rate increases, the situation will be totally different when interest rate decreases. As we know, decrease of interest rate causes increase of bond’s price. However, when interest rate decreases, due to the lowest sensitivity to interest rate change, the price increase of the 10-year bond will also be the least among the three bonds, which means investors will benefit least from interest rate decrease if investing in the 10-year bond.
2. The lowest risk the 10-year bond has results in the lowest coupon rate, which means investors will achieve the lowest return if investing in the 10-year bond.

Decision on 30-year bond:

Pros:

1. Compared with the 100-year bond, the 30-year bond is less sensitive to the interest rate change, which means it has less interest rate risk. However, unlike what it is usually expected to be, the 30-year bond has higher coupon rate than the 100-year bond. Having lower interest rate risks but a higher coupon rate makes the 30-year bond seem to be more attractive than the 100-year bond.

Cons:

1. Due to its higher duration and convexity, long-term bond has a greater sensitivity to interest rate change. To long-term bond, a small increase in the interest rate would result in a substantial decrease in its price. So the price of the 30-year bond is much more volatile than the price of the 10-year bond.
2. Compared with a 10-year bonds, it is more difficult to retire a 30-year bond. So the 30-year bond has lower liquidity.
3. The 30-year bond has the highest coupon rate among the three bonds. So it may face more risk of default.

Our preference:

Based on the analysis above, we prefer buying the 10-year bond for the following reasons.

First of all, Petrobras is an oil company whose profits will suffer from the current slump of oil price, which means investors of Petrobras will face more credit risks. Investing in the 10-year bond can minimize the loss causing by the increasing credit risks.

Secondly, the slump of oil price increases the uncertainty of future interest rate. As we can see from previous analysis, the price of the 10-year bond has the least sensitivity to interest rate changes, so investors of the 10-year bond will be exposed to the least interest rate risks. To ensure the payments of the portfolio, it would be better to choose a bond that is less sensitive to interest rate changes especially when the change of interest rate is extremely uncertain.