What is bond immunization and how does it protect against interest rate risk?

Question

AcadiFi · Accepted Answer

Immunization is a bond portfolio strategy designed to match the duration of assets to the duration of liabilities, so that the portfolio's value moves in parallel with the liability's present value when rates change. The result: the funded status is insulated from small parallel yield-curve shifts. Mechanism: there are two offsetting effects of a rate change on a bond portfolio: 1. PRICE EFFECT: Rate increases → bond prices fall (loss). 2. REINVESTMENT EFFECT: Rate increases → reinvested coupons earn more (gain). When the portfolio's MACAULAY DURATION equals the investment horizon (or liability duration), these two effects exactly offset at the horizon. The realized return equals the YTM at the initial date. Worked example: Ferndale Insurance has a $12M liability due in 7 years. It buys a 10-year bond with 6% coupon, $12M face, Macaulay duration ≈ 7.0, YTM 5%. Day after purchase, rates rise 100 bps to 6%. - Bond price drops (loss ≈ $640K). - But future reinvested coupons now earn 6% instead of 5% for 7 years (gain ≈ $640K PV). - Net: portfolio value at year 7 ≈ liability amount. Immunized! ```mermaid flowchart LR A[Rate Rise] --> B[Price Falls] A --> C[Reinvest
at higher] B --> D{Net at
horizon} C --> D D --> E[Near zero
if D=H] ``` Requirements for classical immunization: 1. Macaulay duration = liability horizon. 2. PV of assets >= PV of liabilities. 3. Convexity of assets >= convexity of liabilities (to protect against non-parallel shifts). Rebalance as time passes because duration and horizon don't decrease 1:1.

What is bond immunization and how does it protect against interest rate risk?

Master Level III with our CFA Course

Related Questions

Practice Questions