Jim Tuck is the trustee of a family trust company, the Tuck Family Trust. The trust was formed by his grandfather Thomas Tuck with the equity of the Tuck magazine company, which he founded, and managed most of his life. The trustees sold the magazine company in 1995 for 70 million dollars, and have been in charge of managing the money since then. The assets have since grown to 100 million, and are held in what is termed a "sprinkling trust" -- it is designed to benefit future as well as present generations. The trust is allowed to pay out only interest income to the beneficiaries, until the last child of Thomas Tuck dies, at which time, the trust is dissolved and it pays out the entirety of its assets -- tax free -- to the beneficiaries.
There are currently 48 beneficiaries who
are receiving quarterly checks from the Tuck Family trust, and the 53 children
of these beneficiaries are themselves future potential beneficiaries. Jim's
fiduciary duties require him to address their needs as well as the needs of the
current recipients. There are four living children of Thomas Tuck, and the
youngest is 75 years old.
The portfolio is managed by Weller and
Beame Investments. The current allocation of the trust, as of January 2003, is
entirely in U.S. government bonds. 2/3 of the portfolio is invested in
long-term governments maturing in February of 2031. The remaining third of the
portfolio is invested in shorter-maturity bonds, maturing in November 2007. The
firm believes the outlook for bonds has dimmed somewhat and now suggests
selling the long-term bonds and investing in short-term maturities. If the
trust sells the long-term bonds to lock in profits, it will pay capital gains
taxes on them -- at the highest marginal rates.
Jim is faced with difficult family
problems. About half of his relatives want the trust to pay out a substantial
income, and about half do not. Those who do not need the income from the trust
would prefer that the assets be allocated to growth securities that will be transferred
to them tax-free when the trust is dissolved. Those who want the current income
are feeling constrained by the cash needs of putting children through college,
buying homes and other major expenses. Needless to say the two factions rarely
agree. Both sides pay taxes on the interest income, and those that have higher
incomes are in the higher tax brackets.
Jim is considering the recommendation
from Patricia Dow at Weller and Beame that he sell the long-term bonds now and
recognize a handsome profit. She suggests that they take the money and purchase
government bonds maturing in November 2007. He trusts Weller and Beame's advice
-- after all, they called the past interest rate movements.
Jim has heard that Inflation-Indexed
Treasury Securities may be a good investment for the family. They promise a
return in real as opposed to nominal terms. If inflation picks up, this may
protect the real value of his family portfolio. On the other hand, these
securities have yields substantially below current fixed income securities.
Some of his relatives have also been
asking him about higher yielding bonds. Mortgage-backed securities have higher
yields, high-yield corporate bond yields are attractive and emerging market
bonds have attracted a lot of attention.
The trustee's meeting is next week, and
Jim must decide upon a reasonable course of action to recommend to his fellow
fiduciaries by then.
|
Tuck Family
Trust Portfolio Jan/25/2003 |
|||
|
Security |
Coupon |
Maturity |
Price |
|
T-Bond |
3 |
11/07 |
100-21 |
|
T-Bond |
5.375 |
2/31 |
107-27 |
Assignment:
Prepare a report for the Tuck trustee
meeting. It should address the following questions:
1) What is the duration of the current
portfolio? How will the value of the portfolio change with a 100 basis point
drop in interest rates?
2) Is the portfolio sufficiently
diversified? How great is the re-investment risk they face in 2007, if they
follow the recommendation of their managers?
4) Suppose that the most risk averse of
the beneficiaries cannot afford to have a drop of 20% in his income flow. When
would such a drop probably occur, and how likely is it that it would be of that
magnitude? How can you characterize the probability distribution of a 20% drop
in income from the portfolio?
4) Find the data on Inflation- Indexed
securities in the U.S. Capital Markets module (SB index near the bottom). Can
you estimate the current market forecast for inflation from the yield on these
securities? Does inflation represent a serious risk?
6) Consider alternative bond portfolios
that have higher yields. Back-test the long-term performance of your bond
portfolio strategy of choice. Report on the long-term risk and return of the
portfolio and the uncertainty about income flow faced by the beneficiaries.
7) What is the relevant horizon they
should consider for the bond portfolio?