Managingbondportfolios

byAnnaBouhailHeadofEducationSAIFM

espitethevolatilityinthefinancialmarketsoverthelastthree
decades,bondportfolioshavebeenshowntoproducelowerlevelsof
bothreturnandvolatilitythanwhatwasshownbyotherassetclasses.
ReillyandWright(2004)confirmedthisintheirexaminationofthe
investmentperformanceof36classesoflongtermsecuritiesovera
21yeartimeframewhichbeganin1980.Reillyetal(2004)also
calculatedthatthecorrelationbetweenfixedincomeandequity
securitiesishistoricallyverylow(0.27)thusmakingbondportfolios
anexcellenttoolfordiversifyingriskwhencombinedwithexisting
portfolios,suchasanequityportfolio.Takingintoconsiderationthese
statisticsitisevidentthatconsiderableopportunitiesexistinbondsfor
individualandinstitutionalinvestorsastoenhancetheriskreturn
performanceoftheirportfolios.
Thisarticlefocusesonthecreationandmanagementofbond
portfoliosasubjectthatreceivedmoreattentioninthelast20years
thanthemanagementofequityportfolios.
Bondportfolioinvestmentstyles
Aninvestmentstyleistheportfoliomanagersapproachorobjective
whenmakingchoicesintheselectionofsecuritiesforaportfolio.
Bondportfoliostylesareclassifiedaccordingtothetwomost
importantcharacteristicsofbondinstruments:maturityandcredit
quality.Bondmaturitiesarecategorizedasshort,intermediateand
longterm.Creditqualityisdeterminedbyratingagenciesandcanbe
classifiedaslow,intermediateandhighgrade.Thesetwoprimary
characteristicsalongwiththeirsubcomponentsmakeforninebasic
investingstylesforbondportfoliosasillustratedinTable1.
Variationsandcombinationsofthesebasiccategories,aswellas
considerationofspecialindustries,industrysectorsandgeographic
location,createinvestmentstylesbeyondthebasicninecategories.
Table 1: Bond portfolio investment styles classified according to maturity and credit quality
Shortterm Mediumterm Long
Highgradeshortterm Highgrademedium Highgrade
Highgrade
investmentstyle terminvestmentstyle investment
Intermediategrade Intermediategrade Intermediat
Intermediate
shortterminvestment mediumterm longtermi
grade
style investmentstyle style
Lowgradeshortterm Lowgradeshortterm Lowgrade
Lowgrade
investmentstyle investmentstyle investment
(AnalysisofInvestmentsandManagementofPortfoliosNinthEdition
Brown/Reilly,p.679)
Bondportfoliomanagementstrategies
Duringthepastdecade,therehasbeenasignificantincreaseinthe
numberandrangeofbondportfoliomanagementstrategiesavailable.
Priortothe1960sonlytwostrategiespassiveandactiveexisted
andmostbondportfoliosweremanagedonabuyandholdbasiswith
theintentionofprovidingafixedincomefortheinvestor.Manyother
strategiesweredevelopedinthe1970sand1980sinordertomeet
theemergingneedofinstitutionalclientsinanincreasinglyvolatile
market.Todaybondportfoliomanagementstrategiesaredividedinto
fivebroadgroups,eachwithitsownsubdivisionsasillustratedin
Figure1.
FIGURE1:BONDPORTFOLIOMANGEMENTSTRATEGIES
Passiveportfoliostrategies
Therearetwospecificpassiveportfoliomanagementstrategies:buy
andholdstrategyandindexing.
Thebuyandholdstrategyseekstoonlyselectaportfoliobasedon
theobjectivesandconstraintsoftheinvestorwiththeintenton
holdingthesebondstomaturity,whereastheindexingstrategy
attemptstoreplicatetheperformanceofagivenbenchmarkusuallya
bondindex.Abuyandholdstrategyinvolvesbuyingbondsthat
matchtheinvestorsrequirementsintermsofyield,maturityand
duration,whilstalsoexaminingfeaturessuchasquality,couponrate,
callfeaturesandsinkingfunds.Thusthebuyandholdstrategyisan
uncomplicatedmanagementplanthatattemptstoreduceactive
tradingandthereforetheassociatedreinvestmentriskandcosts.Many
successfulportfoliomanagersfollowamodifiedbuyandhold
strategyinwhichbondsareboughtwiththeintentionofholdinguntil
maturitybutthemanagerisstillactivelylookingforopportunitiesto
tradeintomoredesirablepositionsshouldtheopportunityarise.
Modifyingthisstrategytoomuchhoweverturnsitintoanactive
strategy.
Anothervariationofthebuyandholdstrategyisthebondladder.A
bondladderisaportfolioofbondswithdifferentmaturities.The
bondsarehelduntilmaturityandtheproceedsreinvestedintoanew
bondwithamaturityatthefarendoftheladder.Theadvantagesof
bondladdersincludeconsistentreturns,lowriskandongoing
liquidityasthebondsmatureregularly.Asthematuritiesare
staggeredtheinvestorisalsoprotectedfromcallriski.e.thereisa
verylowprobabilitythatallbondsintheportfoliowillbecalledat
once.
Thebuyandholdstrategyportfoliomanagermostlyseeksriskfreeor
veryhighqualitybonds.Ingeneralbondswithacallableorputtable
featurewillnotformpartofsuchaportfolioasthiscouldpossibly
altertheinvestorscashflows.Thebuyandholdstrategyminimizes
transactioncost,andifimplementedwisely,canbehighlyproductive.
Ratherthanformingabuyandholdportfoliomanyinvestorspreferto
holdportfoliosthatreflectthecharacteristicsofaselectedbondindex.
Thistypeofstrategyiscalledanindexingstrategy.
Therearetwobasictechniquesforconstructingapassiveindex
portfolio:
Full replication: The most obvious technique is full replication
whereintheportfolioisconstructedbybuyingallthesecurities
inaspecifiedindexinproportiontotheirweightsintheindex.
Althoughfullreplicationensuresclosetracking,thistechnique
is impractical and expensive as a bond index often contains
thousandsofspecificissuesandthebondindexisalsoadjusted
frequently.
Sampling: Sampling addresses the problem of having too many
bond issues. With sampling a portfolio manager only buys a
representativesampleofbondsincludedinthespecifiedindex.
Withasamplingstrategyabondportfoliowillbecreatedthat
matchestheimportantcharacteristicsofthebenchmarkindex;
such as quality, industry composition, maturity, duration and
coupon rate. When selecting the bonds to beincluded in the
portfolioitisimportantfortheinvestortomaintainaportfolio
thatiscosteffectivetomanage.Thedisadvantageofsamplingis
 thatportfolioreturnswillalmostcertainlynottrackthereturns
forthebenchmarkindexascloselyaswithfullreplication;this
iscalledthetrackingerror.
The selection of an appropriate market index a very important
decisionasthiswilldeterminetheriskreturnresultoftheportfolio.It
isimportantforinvestorstobefamiliarwiththecharacteristicsofthe
benchmarkindex.
Thesuccessofpassiveportfoliosismeasuredbyhowcloselytheir
returnsmatchedthoseofthespecifiedbenchmark.Thereforepassive
portfoliomanagersattempttomaintainatrackingerroroflessthan
1%.
Activeportfoliostrategies(i)
Thegoalofactivemanagementismaximizingtotalreturnby
correctlypredictingthemarketorseekingoutmispricedsecurities.
Althoughactiveportfoliostrategiesmayresultinhigherreturnsthan
thoseproducedbypassivemanagementstrategies,theyoftendosoby
exposinginvestorstohigherlevelsofriskaswellascosts.This
articlewillfocusonthefollowingactivebondstrategies:interestrate
anticipation,valuationanalysis,creditrisk,yieldspreadanalysisand
bondswaps.
Interestrateanticipation
Interestrateanticipationisoneofthemostcommonandprobablythe
riskiestoftheactivebondportfoliostrategiessinceitrelieson
uncertainforecastsoffutureinterestrates.Thestrategyisdesignedto
preservecapitalwheninterestratesincrease(thusbondprices
decrease)andtoreceiveasmuchcapitalappreciationaspossible
wheninterestratesdecrease(thusbondpricesincrease).Thiscanbe
donebychangingthedurationofthebondportfolio.Durationofthe
bondportfoliowillbelengthenedinanefforttocaptureanincreasein
thecapitalvalueofthebondwheninterestratesareexpectedtofallin
thenearfuture.Ifinterestratesareexpectedtoriseportfolio
managerswouldstructuretheportfoliotohavethelowestpossible
duration.
Theriskhereliesintheincorrectestimationoftheinterestrate
movementsasitisextremelydifficulttopredictwithaccuracythe
directionofchange,themagnitudethereofandthetiming.Oncethe
portfoliomanageranticipatedthefutureinterestrate,theportfolio
modificationrelieslargelyontechnicalmatters.Itisimportantto
understandtheexecutionofawinninginterestrateanticipation
strategy.
Ifanincreaseininterestratesisanticipatedaportfoliomanagercan
dooneorbothofthefollowing:
Shorten the duration of the portfolio: When interest rates are
expectedtoincrease,theportfoliomanagerwillseektopreserve
capital by reducing the duration of the portfolio. Popular
investment choices will be shortterm obligations such as
TreasuryBills.Theportfoliomanagershouldlookforthebest
possiblereturngiventhematurityconstraints.Theliquidityof
theissueisalsoanimportantfactorasyieldsmayexperiencea
period of stability after the interest rate increase and the
portfolio manager would want to shift positions easily and
quicklytobenefitfromthehigherincomeand/orcapitalgains.
Investinanattractivecushionbond:Acushionbondisahighyield
longtermcallablebondthatcarriesacouponratesubstantially
abovethecurrentmarketrateandhasamarketpricelowerthan
whatitshould(duetothecallablefeatures)giventhemarket
yield.Asaresulttheyieldishigherthannormal.
Portfoliomanagersanticipatingadecreaseininterestratesshould
amendthedurationoftheportfolioasthelongertheduration,the
greaterthepositivepricevolatility.Thehigherthequalityofabond
themoresensitiveitistointerestratechanges.Thereforehighgrade
noncallableorwithstrongcallprotectionbondswillbepreferable.
Zerocouponbondswithlongerdurationsmightalsobeaninvestment
optionaszerocouponbondsarefarmoresensitivetointerestrate
changesthannormalbonds.Onceagaintheliquidityofissuesisan
importantfactorintheinvestmentdecisionasyouwanttobeableto
closeoutyourpositionasquicklyandascheaplyaspossiblewhen
ratesstartstoincreaseagain.
Theportfoliomanagershouldhoweverbevaryoftherisksthatthis
strategyholds.Whenmaturitiesareshortenedtopreservecapital,the
opportunityforcapitalgainscanbelostiftheinterestratesdecline
ratherthanrise.Similarly,theportfolioshiftspromptedby
expectationoflowerinterestratesareveryrisky.Specifically,ifwe
assumethatweareatapeakininterestrates,itislikelythattheyield
curveisdownwardsloping,whichmeansthatbondcouponswill
declinewithincreasedmaturityandtheinvestorissacrificinginterest
incomebyshiftingfromhighcouponshortdurationbondstolonger
durationlowcouponbonds.Theportfolioisalsoexposedtogreater
pricevolatilityaslongerdurationbondsaremorevolatilethanbonds
withshortmaturities.Thismayhaveanegativeimpactonthe
portfolioifanunexpectedincreaseinyieldoccurs.Notethatthe
portfolioadjustmentspromptedbyananticipationofanincreasein
ratesinvolvelessriskofanabsolutecapitalloss.Whenyoureduce
thematurity,theworstthatcanhappenisthatinterestincomeis
reducedand/orcapitalgainsaresacrificed.
Valuationanalysis
Thebasicprincipleofvaluationanalysisisbasedonthemanagers
abilitytoidentifyandpurchaseundervaluedbondsandsellorignore
overvaluedbonds.Undervaluedbondsarebondswithandintrinsic
valuehigherthanthatofthebondscurrentmarketpriceand
overvaluedbondsarebondswithanintrinsicvaluelowerthanthatof
bondscurrentmarketprice.Intrinsicvalueofabondtranslatesinto
theexpectedyieldtomaturity(YTM).TheexpectedYTMofabond
canbedeterminedbyevaluatingallthecharacteristics(forexample
callfeatures,sinkingfundprovisions,maturityetc.)ofthebondand
translatingthenormalcostofthecharacteristicsintermsofyield.The
expectedYTMiscalculatedbyaddingorsubtractingthe
characteristicyieldofthebondfromariskfreecomparablebond.
UndervaluedbondswillhaveanexpectedYTMlowerthantheir
currentmarketYTM.
Asthestrategyrequirescontinuousevaluation,indepthanalysisand
plentyoftradingbasedontheanalysis,anunderstandingofthe
importantvaluationcharacteristicsandbeingabletoaccurately
estimatethecharacteristicsyieldcostisessentialtoexecutethe
strategysuccessfully.
Creditanalysis
Acreditanalysisstrategyinvolvesdetailedanalysisofthebondissuer
todetermineexpectedchangesinitsdefaultriskandultimatelyinthe
creditratingoftheissuer.Theportfoliomanagercanspeculateonthe
changeincreditratingandpossiblymakeaprofit.Ifaportfolio
manageranticipatesariseinthecreditratingoftheissuer,thebond
willbeboughtbeforethechangeandsoldatahigherpriceafterthe
ratingincreased.Bondissuesthatareexpectedtobedowngradedwill
besoldorignored.
Ratingchangesarepromptedbyinternalchangeswithintheissuer
(e.g.changesinimportantfinancialratios)andbychangesinthe
externalenvironment(e.g.changesintheindustryandeconomy).
Historicallytherehasbeenastrongcyclicalpatterntoratingchanges.
Downgradingstypicallyincreaseduringeconomiccontractionsand
decreaseduringeconomicexpansions.Therehavebeenexceptionsto
thisruleforexamplein19851990whendowngradingintheUS
increasedsubstantiallydespitethepositiveeconomicclimate.
Oneofthemostevidentopportunitiesforinvestmentmanagers
followingacreditanalysisstrategyisinvestinginhighyieldjunk
bonds.Junkbondshaveawideyieldspreadoverhigherratedbonds.
Theseyieldspreadsalsotendtowidenduringnegativeeconomic
conditions.AltmanandNammacher(ii)pointedoutthatthenetreturn
ofjunkbonds(averagegrossreturnminuslossesfrombondsthat
defaulted)hasbeenhigherthanthatofhigherratedbonds.Another
studyhasshownthattheaveragecreditqualityofhighyieldbonds
alsochangeovertimeasinterestcoveragetendstofluctuatewiththe
businesscyclethusaffectingthequalityofbondswithinarating
category.Fromthesestudiesithasbeenconcludedthatjunkbonds
canprovidesubstantialratesofreturniftheportfoliomanager
undertakesadetailedcreditanalysistodeterminethosebondsthat
willdefaultornot.
Yieldspreadanalysis
Theyieldspreadisthedifferencebetweentheyieldoftwosecurities
orbetweenasecurityandabenchmark.Withyieldspreadanalysis
theportfoliomanagermonitorsyieldrelationshipsbetweenvarious
typesofbondsandseekoutabnormalitiesinspreads.Ifthespread
wouldbethoughttobeabnormallyhightheportfoliomanagerwould
adjusttheportfoliototakeadvantageofareturntonormality.The
portfoliomanagerthereforeneedtodevelopthebackgroundtoknow
thenormalyieldrelationshipandmustalsoevaluatetheliquidity
necessarytotradetherequiredissuesquicklyenoughastotake
advantageofthetemporaryyieldspreaddeviation.Thedisadvantages
ofthisstrategyarethenumeroustradesthatarerequiredaswellasthe
risksinherentintheincorrecttimingofinterestratechanges.
Thegenerallyacceptedexplanationofchangesintheyieldspreadhas
alwaysbeenseenasrelatedtotheeconomicclimate.Theyieldspread
isseentowidenduringperiodsofeconomiccontractionand
uncertaintyasinvestorsrequirehigherriskpremiumsandthespread
decreasesduringperiodsofexpansion.ApaperbyDialynasend
Edington(iii)furtheraddedtothisviewandimpliedthatwhen
analysingyieldspreads,specificattentionshouldbegiventointerest
ratevolatility.Interestratevolatilityaresaidtoaffectyieldspreadsin
thefollowingways:
Yieldvolatilityandthebehaviourofembeddedoptions: Thevalue
ofacallablebondisthevalueofanoncallablebondminusthe
valueofthecalloption.Anincreaseinyieldvolatilityincreases
thevalueofthecalloption,effectivelydecreasingthevalueof
thecallablebond.Thepricedecreaseinturnaffectsanincrease
in the yield and thus widening the yield spread relative to
Governmentissues.
Yieldvolatilityandtransactionliquidity: Similarly,anincreasein
yieldvolatilitywillincreasetheuncertaintyfacingbonddealers
andwillcauseanincreaseinthebidaskspreads;thesespreads
reflect the transactional liquidity for the related bonds. This
liquiditywillhaveabiggereffectonnongovernmentbonds,so
theiryieldspreadrelativetogovernmentbondswillincrease.
Theeffectofyieldvolatilityonthebusinesscycle: Asinterestrate
volatilitycauseseconomicuncertainty,interestratevolatilityis
usually preceded by a contraction of the economy; the
contractioninturnwillaffectyieldspreads.
Bondswapstrategy
Thekeytoabondswapstrategyistoliquidatethecurrentposition
andsimultaneouslypurchaseanotherissuewithsimilarcharacteristics
forthesolepurposeofimprovingtheportfoliosreturn.Portfolio
managerscanenterintoaswaptoimplementanyoftheabove
mentionedactivebondportfoliomanagementstrategies;entailing
detailedmarketanalysisandprojections.Swapscanalsobeutilisedto
increasecouponratesandtotakeadvantagesofthedifferenttax
statutes.
Thepureyieldpickupswapinvolvestheswappingoflowercoupon
bondsforhighercouponbondsthusrealisinganautomaticincreasein
currentyieldandyieldtomaturity.Theinvestordoesnotneedto
predictanyfutureratechanges.Theswapisalsonotbasedonany
imbalanceinyieldspreadorcreditquality.Themajorriskisthat
futurereinvestmentratesmightnotbeashighasexpectedresultingin
lowerthanexpectedtotalreturnontheinvestment.Theportfolio
managershouldevaluateinvestmentriskinordertodetermineifthe
swapwillbefeasible.Ifthemanagerdoesnotswaptheexistingbonds
withbondsofsamematurityand/orcreditquality,theinvestment
mightbeexposedtohigherinterestrateriskand/orhigherdefault
risk.
Aswiththeyieldswap,thetaxswapisbondspecificanddoesnot
involvemarketprojections.Thetaxswapismerelyasaleofabond
thathaddeclinedinpricesinceitspurchaseandtheimmediate
purchaseofabondwithsimilarmaturity,couponandfeatures,in
ordertorealizealossfortaxpurposeswhilemaintainingthecurrent
position.
Coreplusmanagementstrategies
Inrecentyearsportfoliomanagersseekinginvestmentsolutionshave
adoptedstylesthatcombinepassiveandactivemanagement
strategies.Thecoreplusmanagementstrategyisonesuchstrategy.
Thisstrategyseekstopassivelymanagealargeproportion
(sometimesasmuchas80%)oftheportfoliobyinvestingina
conservativeportfolioconsistingofgovernmentandhighquality
corporatebonds;thisisthecoreofthestrategy.Theremainderofthe
portfoliowillbemanagedactivelyintheplusportionofthe
portfolio.Theportfoliocorerepresentsastablefoundationthat
couldabsorbthehigherriskandhigherreturnpotentialoftheplus
portionoftheportfoliowithoutchangingtheconservativeprofileof
theportfolio.
Enhancedindexingisacoreplusmanagementstrategywherethecore
partoftheportfolioisstructuredtomirroranindexorbenchmark.
Theportfolioisgraduallyadjustedbysellingpoorperformingbonds
andinvestingthereturninbondswithhigherriskadjustedreturns.
Thisstrategythereforeattemptstoamplifythereturnofanunderlying
indexwhilstalsominimizingtheeffectsoftrackingerror.
Matchedfundingmanagementstrategies
Matchedfundingtechniqueswheredevelopedinthe1980swhen
interestratesreachednewlevelsofvolatility.Institutionscouldnot
meettheirobligationsbyliquidatingtheirbondportfoliosasinterest
rateswerehigh,subsequentlycausingadecreaseinthepriceof
bonds.Thusmanyinvestorswantedastrategythatcouldmatchfuture
liabilitystreamswithouthavingtoworryaboutinterestrate
fluctuations.Thematchedfundingmanagementstrategyisa
holisticinvestmentstrategyastheportfoliomanagerattemptsto
matchfutureliabilitiestoaportfolioofbonds.Thisstrategyis
designedforsituationswherefutureliabilitiescanbepredictedwith
somedegreeofaccuracyforexampleapensionfundthatneedto
makefuturepayoutstopensionersovertheirexpectedlifetimes.A
varietyofmatchfundingtechniquescameintobeingandthemost
prevalentstrategieswillbediscussed.
Dedicatedportfoliostrategies
Dedicationreferstoapassiveportfoliomanagementtechniquethat
involvesthematchingoffuturecashinflowswithfutureliabilities.
Thistechniquemaybeusedasanalternativetoimmunizationorin
combinationwithit.Themostconservativemannerinwhichto
dedicateaportfoliowillbetoconstructaportfolioofhighquality
bondsthatwillbehelduntilmaturityinordertoprovideapredictable
streamofcashflowsfromcouponpaymentsandrepaymentof
principalatmaturity.Theobjectiveofthisseriesofcashinflowsisto
exactlymatchthetimingofapredictableseriesofcashoutflows.For
example,ifafinancialcompanyisobligedtopayoutR1millionin10
years,itcanprotectitselfbybuyingandholdingabondthatmatures
in10yearsandhasaredemptionvalueofR1million.Thus,the
companysexpectedcashinflowswouldexactlymatchitsexpected
liabilityandachangeininterestrateswouldnotaffectthefirm's
abilitytopayitsobligations.Thistechniqueiscalledapurecash
matchdedication.Alternativelytheportfoliomanagermayoptto
createaportfolioofwhichthecashflowsdonotexactlymatchthe
liabilities,buttoreinvestanyinflowsthatprecedetheliabilityclaims
atareasonablyconservativerate.Thistechniqueiscalleddedication
withreinvestmentandallowsforhigherreturnsandlowercostasthe
cashflowsarereinvested,withoutcompromisingthesafetyofthe
portfolio.
Themostimportantadvantageofdedicationistheavoidanceor
reductionofinvestmentrisks.Anumberofrisksassociatedwith
owningbondsareavoidedormitigatedbyusingadedicatedportfolio:
Marketrisk:Marketriskisavoidedasthebondsareheldtomaturity
Inflationrisk:Inflationriskcanbemitigatedbybuildinginan
anticipatedinflationadjustmentintothetargetcashflows
Defaultrisk:Defaultriskisreducedasdedicatedportfoliosare
usuallyconstructedfromhighqualitybonds
Asdedicatedportfoliosareusuallymadeupofhighqualitybonds,
thereisgenerallynoneedtorebalancetheportfolio.Theprimary
disadvantageofdedicatedportfoliosisthattheyarenoteasyto
construct.Expertiseinbondsandotherfixedincomesecuritiesis
required.Thisstrategyisnotaswidelypursuedbecauseofthe
constraintsimposedonbondselection.Bondssuchascallablebonds
arenotsuitableasthisfeaturecandisturbtheexpectedflowof
incomewhencalled.Theportfoliomanagermightalsonotbeableto
utiliseopportunitiesforpossiblehighergainsasavailableunderpriced
bondsmightnotbeasuitablematchforthesetofliabilitiesthatneeds
tobeserved.Sometimescashflowmatchingissimplynotpossible.
Forexampleapensionfundthatisobligedtopayoutaperpetualflow
ofincomewillbeunabletomatchtheliabilityasamatchingbond
doesnotexist,makingexactdedicationimpossible.(iv)Insuch
instancestheportfoliowillneedtoberolledoverrequiringongoing
adjustmentsandintensivemanagement.
Classicalimmunization
Classicalimmunizationisastrategythatattemptstoensurethata
changeininterestratesdoesnotaffectthecurrentorfuturevalueofa
portfolio.Institutionssuchasbanksmustprotecttheircurrentnet
worthagainstinterestratechanges.Banksliabilitiesaremostly
deposits,mostofthemofshorttermnature,andtheirassetsare
mostlyoutstandingcommercialandconsumerloansormortgages,
thatareofalongtermnature.Bankscansufferseriousdecreasesin
networthwhentheinterestrateincreasesunexpectedlyasthebanks
assetswilldecreasemoreinvaluethantheliabilities.Althoughother
institutionssuchaspensionfundsfacepaymentobligationsina
numberofyears,amismatchbetweentheinterestratesensitivityof
theassetsandthepresentvalueoftheliabilitiesmightstillexist.The
notionofimmunizationwasintroducedbyRedington(1952)(v),an
actuaryofalifeinsurancecompany.Theideabehindimmunizationis
tomatchthedurationofassetsandliabilities,thereforeprotectingthe
portfolioagainstinterestratefluctuations.
FisherandWeil(1971)showedthatpriceriskandreinvestmentrisk
areaffectedinverselybychangesintheinterestratesandthatduration
isthetimeperiodwhentheserisksareofequalmagnitude,butin
oppositedirections.Thepriceofabondwillincreasewithadecrease
ininterestrateswhereasthereinvestmentrateatwhichthecoupon
canbereinvestedwilldecreaseandviceversa.FisherandWeil
(1971)specifiedthepreciseimmunizationprocesstoeliminate
interestrateriskbydurationmatching.FisherandWeilarguedthata
portfoliohasbeenimmunizedifitsvalueattheendoftheperiodis
thesame(orhigher)thanwhatitwouldhavebeenifinterestrateshad
notchangedduringtheinvestmenthorizon.FisherandWeilhave
shownthataportfoliocanbeimmunizedundertheassumptionthat
interestratechangeswillaffectallratesbythesameamount.For
exampleallrates(longtermandshorttermbonds)willrisebyabasis
pointorfallbyabasispointforagivenchangeininterestratesi.e.
yieldcurveshiftsisparallel.Underthisassumptionaportfoliocanbe
immunizedbyholdingaportfolioofbondswithamodifiedduration
equaltotheremaininginvestmenthorizon.Figure2illustratesthe
stepstobetakenwhenconstructinganimmunizedportfolio.
Figure2:CONSTRUCTINGANIMMUNIZEDPORTFOLIO
Furthertothisportfoliomanagersshouldbeabletoincreasethe
portfoliosprofitabilitybyconstructingaportfoliowherethe
convexityoftheassetsexceedstheconvexityoftheliabilities.Thus
whenratesmovesubstantiallythebondvalueexceedthepresent
valueoftheobligationbyanoticeableamount.
Thedisadvantageassociatedwithdurationmatchingisthatitassumes
thedurationsofassetsandliabilitiesremainunchanged,whichis
rarelythecase.Thereforeanimmunizedportfolioneedstobe
rebalancedcontinuallyasinterestratesandassetdurationschangeto
rematchdurationoftheportfoliowiththedurationoftheobligation.
Asrebalancingattractstransactioncosts,anappropriatecompromise
mustbeestablishedbetweenthedesireforperfectimmunizationand
theneedtocontrolcosts,whichmeanslessfrequentrebalancing.
Horizonmatching
Horizonmatchingisacombinationofthetwostrategiesdiscussedin
thesubsectionsabove:cashmatchingdedicationandimmunization.
Theliabilitystreamisdividedintotwotimehorizons.Thebond
portfolioisconstructedtoprovideacashmatchforliabilitiesduring
thefirsttimehorizonandtocoverliabilitiesduringthesecondtime
horizonbyusingdurationmatchingi.e.immunization.Thisconceptis
illustratedinFigure3.
Figure3:HORIZONMATCHING
Horizonmatchingensuresthatliabilitieswillbemetwithcertainty
duringtheearlyyears,butallowsformoreflexibilityinthesecond
timehorizonoftheportfolio.Oneoftheproblemsofclassical
immunizationisthatthestrategyisnotabletoaccommodatenon
parallelshiftsintheyieldcurve.Nonparallelshiftmostlyoccursin
theshortendoftheyieldcurveandthereforehorizonmatching
eliminatestheproblemofnonparallelshiftsastheshortterm
liabilitiesarecoveredbycashmatching.Theportfoliomanager
shouldconsiderdifferentcombinationsofhorizonsastodetermine
whichcombinationofcertaintyagainstflexibilitywillsuittheneeds
ofportfoliothebest.Thecashmatchedsectioncanalsoberolledover
timeespeciallyduringperiodsofparallelshiftsintheyieldcurve.
ContingentImmunisation&StructuredStrategies
Contingentimmunizationisamixedpassiveactivestrategysuggested
byLiebowitzandWeinberger(vi)inwhichtheportfoliomanager
replacesanactivestrategywithanimmunizationstrategyifthereturn
ontheportfoliofallsbelowasetthreshold.Forexample,ifruling
interestratesare12%theimmunizationplanmightbeusedtolockin
areturnof10%,thusallowinga2%safetynettoactivelyseekhigher
returns.Ifpotentialreturndropsto10%,theimmunizationstrategy
willapplyandthedurationoftheportfoliowillbeadjustedtomatch
thedurationoftheliabilities.Contingentimmunisationisatypeof
structuredactivemanagementstrategy.Otherstructuredstrategies
alsoseektomatchorexceedtheperformanceofspecificfuture
liabilitiesbuttypicallyinvolvesupplementingthebondsheldinthe
portfoliowithderivativepositions.
Inclosing
Thegrowthofthefixedincomemarketoverthepasttwodecades
certainlyamplifiedtheimportanceofbondsecuritiesandespecially
themanagementthereof.Themarketexperiencedasignificantgrowth
insize,sophisticationandspecialisationwhichinturnhascreated
variouscareeropportunitieswithinthissector;includingtrading,
valuation,creditanalysisandportfoliomanagement.

(i)ThissectionreliesheavilyonAnalysisofinvestmentsandmanagementofportfoliosNinthEdition
Brown/Reillypages683to690
(ii)InvestinginJunkBonds:InsidethehighyielddebtmarketEAltman/ANammacjer(2002)
(iii)ChrisP.DialynasandDavidH.EdingtonBondyieldspreadsApostmodernViewJournalofPortfolio
management19,no1(Fall1992):6075
(iv)Investments(eightedition);ZVIBodie,AlexKane,AlanJMarcuspage538
(v)F.M.Redington,ReviewofthePrincipleofLifeOfficeValuationsJournaloftheInstituteofActuaries78
(1952)
(vi)MLLiebowitzandWeinbergerContingentImmunizationPartI:RiskcontrolproceduresFinancial
AnalystsJournal38(Nov/Dec1982)