Bond immunisation is a passive investment strategy that takes advantage of the duration of bonds. Bond investors wanting to plan their investments efficiently employ it over the long term. As an educated investor, you should know about this investment strategy and how to apply it to your portfolio.
What is bond immunisation?
Bond immunisation is an investment strategy used to minimise the interest rate risk of bond investments by adjusting the portfolio duration to match the investor's investment time horizon. It does this by locking in a fixed rate of return during the amount of time an investor plans to keep the investment without cashing it in.
Normally, interest rates affect bond prices inversely. When interest rates go up, bond prices go down. But when a bond portfolio is immunised, the investor receives a specific rate of return over a given time period regardless of what happens to interest rates during that time. In other words, the bond is "immune" to fluctuating interest rates.
To immunise a bond portfolio, you need to know the duration of the bonds in the portfolio and adjust the portfolio so that the portfolio's duration equals the investment time horizon. For example, suppose you need to have £50,000 in five years time for your child's education. You might decide to invest in bonds. You can immunise your bond portfolio by selecting bonds that will equal exactly £50,000 in five years regardless of interest rate changes. You can buy one zero-coupon bond that will mature in five years to equal £50,000, or several coupon bonds each with a five year duration, or several bonds that "average" a five-year duration.
Duration measures a bond's market risk and price volatility in response to a given change in interest rates--it is a weighted average of the bond's cash flows over its life. The weights are the present value of each interest payment as a percentage of the bond's full price. The longer the duration of a bond, the greater its price volatility. Duration is used to determine how a bond will react to changing interest rates. For example, if interest rates rise 1%, a bond with a two-year duration will fall about 2% in value.
You needn't worry about doing the calculations as you can obtain a bond's (or bond fund's) duration from a broker or adviser. Using bonds' durations, you can build a bond portfolio immune to interest rate risk.
Effects of bond immunisation
Changes to interest rates actually affect two parts of a bond's value. One of them is a change in the bond's price, or price effect. When interest rates change before the bond matures, the bond's final value changes, too. An increase in interest rates means new bond issues offer higher earnings, so the prices of older bonds decline on the secondary market.
Interest rate fluctuations also affect a bond's reinvestment risk. When interest rates rise, a bond's coupon may be reinvested at a higher rate. When they decrease, bond coupons can only be reinvested at the new, lower rates.
Interest rate changes have opposite effects on a bond's price and reinvestment opportunities. While an increase in rates hurts a bond's price, it helps the bond's reinvestment rate. The goal of immunisation is to offset these two changes to an investor's bond value, leaving its worth unchanged.
A portfolio is immunised when its duration equals the investor's time horizon. At this point, any changes to interest rates will affect both price and reinvestment at the same rate, keeping the portfolio's rate of return the same. Maintaining an immunised portfolio means rebalancing the portfolio's average duration every time interest rates change, so that the average duration continues to equal the investor's time horizon.
A more direct form of immunisation, "dedicating" a portfolio not only matches its duration to the investor's long-term time horizon, but also matches specific anticipated receipts of cash to the investor's specific anticipated liabilities along the way. To pay for a child's university education, for example, a parent might construct a bond portfolio so that interest and principal payments will be paid each year in September, when tuition is due.
Variations on bond immunisation
The most common way to immunise a bond portfolio is called combination matching. In combination matching, the portfolio not only matches its duration to its time horizon, but also its cash flow and goals. For the first several years of the portfolio, the cash flow from any maturing principal (plus coupon and reinvestment income) is made to equal the intermediate investment goals set for the portfolio. Cash flow is paid out to fund intermediate goal payments, giving the portfolio very little cash to reinvest and thus little reinvestment risk. The low reinvestment risk helps the portfolio to lock in a rate of return regardless of interest rate changes.
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