Bond Immunisation
Bond Immunisation
Ravi (IBA)
Bond Immunization
Bond immunization is an investment
strategy used to minimize 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.
Immunization
Immunization locks in a fixed rate of return during
the amount of time an investor plans to keep the
bond 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 immunized, 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.
Bond Immunization
To immunize 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 for your
child's education. You might decide to
invest in bonds.
Bond Immunization
You can immunize 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.
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.
Variations on Bond
Immunization
The most common way to immunize 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.
Variations on Bond
Immunization
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.
Interest Immunization
We know that investment in the bonds is subject to
three risks
(i) Default risk
(ii) interest risk and
(iii) reinvestment rate risk.
The first one is referred as unsystematic risk while the
other two are referred as systematic risks. Immunization
is a strategy that takes care of systematic risk.
It ensures that a change in interest rate will not affect
the expected return from a bond portfolio.
.
Interest Immunization
Change in interest rates affects the return
from the bonds investment in two ways
(i) there is change in the value of the bond
and
(ii) change in the income from the
reinvestment.
Changes in interest rates have opposite
effects of change in bond values and that in
reinvestment incomes.
Interest Immunization
For example, an increase in interest rates
hurts the bond value; it helps by increasing
the return from the reinvestments and
vice-versa.
Immunization aims at offsetting the effects
of the two changes so that the investors
total return remains constant regardless of
whether there is rise or fall in the interest
rates
Immunization Bonds
A portfolio is immunized when its duration
(average duration of the bonds
constituting the portfolio; weights being
the amounts of the investments in
different bonds) equals the investor's time
horizon.
In other words, if the average duration of
portfolio equals the investors planed
investment period, the realized return
equals to the expected return.
(W1 x 4 ) + (1 - W1) x 11 = 6,
Solving the equation we get, W1 = 5/7
Present value of the obligation = 12411 / (1.10)6
= Rs.7,000
The company may invest Rs. 5000 in zero coupon
bond (Maturity value Rs.7321) and Rs.2000 in
Irredeemable bond.
If market interest continues to be 10%, the
investment will fetch Rs.12411
(assuming that all intermediary cash inflows will
be invested at 10% p.a. without any loss of time)