Pension Plan: Structure and Justification

This document discusses the structure and justification of a pension plan that includes corporate, government, agency, and municipal bonds. It explains the features of each bond type and their role in the portfolio. The document also provides information on the expected return and variance of the bond portfolio.

Running Head: PENSION PLAN
PENSION PLAN
Name of the Student:
Name of the University:
Author’s Note:

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Table of contents
Introduction................................................................................................................................2
Proposed structure......................................................................................................................5
Justification................................................................................................................................7
Bibliography...............................................................................................................................9

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Introduction
Bonds are considered as a fixed income debt instrument or securities that an investors
provides to a borrower. The companies, governments and the municipalities uses this fixed
income instrument as a way of financing the expenses related to the projects and operations.
The owners of the bonds are known as debt holders, creditors or issuer. Whenever there is a
need to raise money for the entities in order to finance new projects, operations or refinancing
debts they directly opt for issuing bonds to the investors (Klass, Silverman and Nickman,
2014). A bond is a loan instrument that includes an issuer who issues the bond at a principle
amount which has to be paid back at a maturity period. It includes a coupon payment which is
made by the issuer of the bond at a predetermined rate (Oscar, Figueroaand Montoya, 2015).
Different types of bonds are issued by the borrowers depending upon the needs and the
categories of the bonds are as follows:
 Government bonds
 Corporate bonds
 Junk bonds
 Investment grade bonds
 Treasury bonds
 Municipal bonds
 Mortgage backend bonds
The employee defined benefit pension plan involves investing into four types of bonds
namely corporate, government, agency and municipal bonds and thus making a bond
portfolio from the combination. These bonds along with their features are discussed in the
following section.
Government bond

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Government bond is considered as a debt instrument that is issued by the government itself in
order to finance the expenditure and support public spending.
 Issuer: The issuer of the government bond in the pension benefit plan is US
government having a face value of $1000.
 Coupon: The coupon rate in this pension plan is 8% and is compounded annually, the
coupon payment in this case is $80.
 Maturity: The maturity period in this government bond is five years.
 State of the economy: The US economy is strong therefore the demand for the money
is high which indicates more need of liquidity in the market in order to finance
projects and hence leads to the rise in interest rates.
 Financial market conditions: The economy of US is in the boom phase and hence the
investors are selling off their bonds in order to buy new stocks for higher return (Ross,
2019).
Corporate bond
Corporate bonds are the fixed income securities that are issued by corporations in order to
finance the expenditures of the organization. The corporate bonds generally have higher
yields than the government bonds.
 Issuer: The issuer of the bond is JP Morgan.
 Coupon: The coupon rate is 10% and compounding annually.
 Maturity: The corporate bond in this case is intermediate corporate bond having a
maturity period of five years.
 State of the economy: The state of the economy has an effect in the interest rate of the
corporate bonds that is growth in the economy of the nation leads to the increase in
the interest rates of the corporate bonds.

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 Financial market conditions: The financial market in US is stable and hence there is
no interest rate risk in the financial market.
 Industry sector: The industry sector in this case is banking sector.
Agency bonds
Agency bond s are the debt instruments that are issued by the government agencies (Ge and
Kim, 2014).
 Issuer: Issued by Federal Housing Administration with a minimum amount of $10000.
 Coupon: The coupon rate is 5% and compounded semi-annually.
 Maturity: The maturity period is five years.
 Financial market conditions: The agency bonds generally faces interest rate risks that
is the change in the interest rates affects the prices of the long term bonds.
 Industry sector: The industry sector in this case is housing administration sector.
Municipal bonds
Municipal bonds are the debts that the local governments make.
 Issuer: Issued by local government of US.
 Coupon: The coupon rate is 9%.
 Maturity: The maturity period is five years.
 State of the economy: When there is a shift in economy the investment in
municipality bonds increases.
 Financial market conditions: The fluctuations in the interest in case of these bonds are
low and hence is regarded as lower risk bonds.

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Proposed structure
The pension benefit plan includes the investment in four types of bonds namely corporate
bonds, government bonds, agency bonds and municipal bonds. The various features of the
bonds along with the price, coupon rates and maturities are discussed in the above section the
structure of the portfolio is the point of discussion in this section (Bessembinder, Jacobsen,
Maxwell and Venkataraman, 2018).
Table 1: Structure of Bond Portfolio
Source: Created by learner
The convexity of the bond aims at measuring the extent of non- liner relationship that exists
between the yield and price of the bond. One of the major principle related to bond pricing is
the yield and the bond price are inversely related to each other that is if the yield of the bond
increases the price of the bond tends to fall. This relationship between the bond price and
yield can be defined in a convex curve rather than a straight line (Chen, Cui and Milbradt,
2017). The curvature reveals the change in the duration of the bond with the change in the
yield of the bond. The formula of bond convexity is as follows:
STRUCTURE OF
BOND
PORTFOLIO
BONDS
FACE
VALUE
COUPO
N YTM DURATION CONVEXITY PRICE
Corporate bond 1000 10% 8%
5
Years
24.901
4 1080.11
Government
bond 1000 8% 6%
5
years 26.052 1084.317
Agency bond 10000 5% 7% 5years
26.159
5 9166.458
Municipal bond 1000 9% 10%
5
years
24.043
7 961.9225

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Convexity = 1/ P * (1 + y)2 ∑ [CFt/(1 + y)t * (t2 + t)]
Where, P is bond price
y is YTM
T is maturity in years
CF is cash flow at time t.
BOND PORTFOLIO FOR PENSION PLAN
Bonds Probability (P) Return ® Expected Return (P*R) Variance
Corporate Bonds 25% 8.01% 2.0027500% 0.000592496
Government Bonds 40% 8.44% 3.3760000% 0.001122434
Agency Bonds 20% -8.33% -1.6660000% 0.00263248
Municipal Bonds 15% -3.80% -0.5700000% 0.000723027
3.1427500% 0.005070437
Table 2: Bond portfolio for pension plan
Source: Created by learner
The 40% of the portfolio is invested in the US government bonds in this pension benefit plan,
25% of the portfolio invested in corporate bonds issued by JP Morgan, and the rest of the
portfolio is invested in agency and municipal bonds. The possible return from corporate and
government bonds are positive whereas the possible return from agency bonds and municipal
bonds are negative (Helwege, Huang and Wang, 2014).
The expected return of an asset or portfolio can be defined the value that is expected from the
probability distribution. The return on the assets or investments is always associated with the
probabilities and hence the expected return can be determined by multiplying the possible
returns with probability that is R1P1 + R2P2 + …… + RnPn where R is the possible return and
P is the probability of the return. The portfolio variance aims at measuring the fluctuations of
aggregate returns from a set of securities. The variance of the portfolio is a dispersion

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measure in the outcomes that is around the expected return of the portfolio as this is an
indication of risk associated with the portfolio. The expected return from the bond portfolio is
3.14% and the variance is 0.5% that is less than 1 (Zey, 2017).
Justification
The proposed structure of the portfolio for the pension benefit plan includes four different
types of bonds along with the expected return and variance. The reasons behind selecting the
bonds are the point of discussion in this section (Ang et al., 2017). Corporate bonds are the
fixed income securities issued by certain corporations to finance their expenditures and this is
regarded as the safest investment at the time of financial crisis. The most appealing features
associated with this security is the interest rate paid by the corporation. The investment in
corporate bonds allows the investors to trade in the financial market soon after the issuance
(Kalotay and Howard, 2014). The investors can make profits accordingly by selling or
purchasing the bonds depending upon the price level. The widespread option are available
with the type of corporate bonds such as short term bonds, medium term bonds and the long
term bonds. In this pension plan the corporate bond is issued by JP Morgan for the time
period of five years along with the coupon rate of 10%.
In order to finance the expenditure or to raise the money for certain projects government
issues bonds and depending on the investment goals government provides a list of unique
benefits to the bondholders. The main reason of including the government bond in the
pension plan is that it provides tax benefits (Gayer, Drukker and Gold, 2016). The interest on
the government bonds are exempted from taxes. These kind of bonds are supported by US
government and is regarded as safest investment. In case of other bonds this level of security
is not available that is if the company is headed towards bankrupt then the entire investment
would face a loss. The government bonds are not subjected to the interest rate risk due to the
fixed rate of interest (Kalotay, 2014).

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Agency bonds are the fixed income debt instruments and is considered as the safest
investment due to their lower level of interest risk and high liquidity. Agency bonds are
issued by government as well as by the corporations sponsored by governments. The main
reason for including this bond in the pension plan portfolio is this provides liquidity to the
investors that is the investors can make profits by selling off the bonds before the completion
of the maturity period.
The major advantage of having municipal bonds and US government bonds in the portfolio is
that they both are exempted from federal tax. The default rates in the case of municipal bonds
are relatively low as compared to other bonds and also have bond insurance feature in order
to save the investors from default risks. The liquidity rate of municipal bonds are also high as
compared to other bonds.
From the above discussion it can be concluded that the pension benefit plan portfolio that
includes four different types of bonds will provide the liquidity as well stability in the
investment as well as are subjected to lower risks. The correlation between the bonds are
neutral that is the change in the price of one bond in the portfolio will not affect the other
bonds in the set.

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Bibliography
Ang, A., Green, R.C., Longstaff, F.A. and Xing, Y., 2017. Advance refundings of municipal
bonds. The Journal of Finance, 72(4), pp.1645-1682.
Bessembinder, H., Jacobsen, S., Maxwell, W. and Venkataraman, K., 2018. Capital
commitment and illiquidity in corporate bonds. The Journal of Finance, 73(4),
pp.1615-1661.
Chen, H., Cui, R., He, Z. and Milbradt, K., 2017. Quantifying liquidity and default risks of
corporate bonds over the business cycle. The Review of Financial Studies, 31(3),
pp.852-897.
Gayer, T., Drukker, A. and Gold, A.K., 2016. Tax-exempt municipal bonds and the financing
of professional sports stadiums. Economic Studies at Brookings.
Ge, W. and Kim, J.B., 2014. Real earnings management and the cost of new corporate
bonds. Journal of Business Research, 67(4), pp.641-647.
Helwege, J., Huang, J.Z. and Wang, Y., 2014. Liquidity effects in corporate bond
spreads. Journal of Banking & Finance, 45, pp.105-116.
Kalotay, A. and Howard, C.D., 2014. The tax option in municipal bonds. Journal of Portfolio
Management, 40(2), pp.94-102.
Kalotay, A., 2014. Optimal Tax Management of Municipal Bonds. Journal of Portfolio
Management, 41(1), pp.85-94.
Klass, D., Silverman, P.R. and Nickman, S., 2014. Continuing bonds: New understandings of
grief. Taylor & Francis.

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Oscar, V., Figueroa, E.G. and Montoya, D.A., 2015. An actual Position Benchmark for
Mexican pension funds performance. Economía: Teoría y práctica, (43), pp.133-154.
Ross, A., 2019. Values and Issues. In Finding Political Identities (pp. 45-95). Palgrave
Macmillan, Cham.
Zey, M., 2017. Banking on fraud: Drexel, junk bonds, and buyouts. Routledge.