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Bond Immunisation

Bond immunization is an investment strategy that aims to minimize interest rate risk by matching the duration of a bond portfolio to the investor's time horizon. It locks in a fixed rate of return regardless of interest rate movements during the investment period. To immunize a portfolio, the duration must equal the time to the required cash outflows. This offsets the opposing impacts of interest rate changes on bond prices and reinvestment returns, leaving the overall return unchanged.
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0% found this document useful (0 votes)
1K views29 pages

Bond Immunisation

Bond immunization is an investment strategy that aims to minimize interest rate risk by matching the duration of a bond portfolio to the investor's time horizon. It locks in a fixed rate of return regardless of interest rate movements during the investment period. To immunize a portfolio, the duration must equal the time to the required cash outflows. This offsets the opposing impacts of interest rate changes on bond prices and reinvestment returns, leaving the overall return unchanged.
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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.

Duration measures a bond's market


risk and price volatility in response to
a given change in interest rates.
Duration 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

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.

Reinvestment Rate & Bonds


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 immunization is to offset these two
changes to an investor's bond value, leaving its
worth unchanged.

Maintaining an immunized 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 immunization,


"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 college, 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
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.

Protection from Changing Interest Rates

Immunization can protect you from


changes in interest rates, which can
affect the prices and reinvestment
rates of bonds.
In order to immunize, investors match
the duration of their bond
investments and their investment
time horizon--the time when they will
need the cash from the investment.

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.

Mr. X has to pay Rs.10,000 after 5 years from today.


He wants to fund this obligation today only. On
enquiry he gathers that a company has come out
with a initial public offer of 8% Bonds (face value
Rs.100) maturity 6 years. Interest on such bonds is
payable annually.
He invests Rs.6800 in the offer.
What amount he will accumulate if market interest
rate continues to be 8%. What if the market interest
falls to 6% or rises to 10% immediately after his
investment in the bonds.
Do you have any offer to comment these amounts?

In all the three cases, the total realization


is almost the same (there is negligible
difference due to calculations
approximations). This is possible only in
one case
i.e. the duration of the bond investment
matches with the investors time horizon,
i.e. the duration is 5. Lets check the
duration of this bond investment:

Duration = XW / W = 34,064 / 6,799 = 5.01


(it is as good as 5)
The investors time horizon matches with the
duration of the bond.
Hence, the change in the market rates could
not change the return; in other words, the
bond investment remains immunized against
the interest rate risk (also known as systematic
risk) as the duration of the bond investment
matched with investors time horizon.

A company has to pay Rs.12411 after 6 years from


today. Current market interest rate is 10%. It wants
to fund this obligation today only.
The following two bonds provide 10% return:
(1) Zero coupon bond maturity : 4 years
(2) 10% Irredeemable bond
Suggest bond portfolio which is immunized against
the systematic risk. What amount you will receive
at the end of 6 years by redeeming this portfolio.
What if the current market interest changes to 11%
at the end of 2nd year.

Duration of zero coupon bond is 4


and that of irredeemable bond is 11.
The investment for funding the
obligation should have duration of 6
for being immunized against interest
rate change.
Lets invest W1 in zero coupon bond
and
1- W1 in irredeemable bond.

(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)

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