Immunization

CFA Level III Fixed Income
#1

I understand the concept of immunization in the context that if interest rates rise, the bond price declines, however the coupon can be re-invested at a higher interest rate when these two exactly offset we have essentially immunized.

However, in the case that I were to be buy a lot of bonds, and interest rates declines, well my bond price goes up, but now I have to re-invest at a lower interest rate, how does one immunize? Does this mean I would have to sell my bonds that increased in price, capture that gain and reinvest? (if I don’t and wait till maturity, I just receive facevalue)

The book says when this happens, the total return is then less than the target yield. Therefore, investing in a coupon bond with a YTM = Target Yield and a Maturity = Investment Horizon does not assure that the Target Value will be acheived…

Can anyone add color?

#2

My take is this, if interest rates are increasing (upward yield curve), then you could do with a target immunisation rate rate that is lower than YTM bond as the coupons are invested at higher ratees. Hence the CFAI books says immunisation rate < YTM for upward yiled curve. I guess the same reasoning for downward slowing curve ie you would need a higher immunisation rate if the interests rate falling.

#3

immunisation is a play between the reinvestment of coupons and the final price of the bond.

rates rise - coupons get reinvested at a higher rate but the final bond price drops.

rates fall - coupons get reinvested at a lower rate but the final bond price rises.

usually - the change in final bond price IS MUCH GREATER than the change in reinvested coupons.

if your immunisation strategy also reaches maturity at the same time as the bond - this would lead to you losing out if rates rise.

#4

cpk123—

Can you explain that last part in more detail “if your immunisation strategy also reaches maturity at the same time as the bond - this would lead to you losing out if rates rise.”

How, if my immunization strategy reaches maturity at the same time as the bond, then I take the proceeds and pay off the liability…trying to understand how I would lose if I-rates rise

#5

^ remember that you are matching duration of your bond to your investment horizon (not maturity), thus your bond won’t mature before your horizon ends. Thus at the end of the your investment period you would sell your bond with higher price than facevalue. In theory, in case of the interest rate level decline, your lose only with reinvestment of your interest at a lower rate but should be offset by amount that you gain from selling you bond at a higher price.

#6

Remember that the liability grows if interest rates rises. Hence CPK has made that statement. cp, correct me if I am wrong please.

#7

you are right Sooraj. When rates rise, your fixed income asset drops in value.

very often your liabilities and assets move in opposite directions.