…just trying to expand on what I’ve learned so far. When would we prefer (accept) a Barbell to a Bullet portfolio in the case of immunization?
You would never prefer a Barbell strategy unless you’re setting up a 2-bond hedge when dealing with MBS. The bullet strategy is always preferred to Barbell when hedging liabilities because it provides/has lower re-investment rate risk. Remember, when immunization liabilities, you’re trying to eliminate/reduce interest rate risk which is price risk and re-investment rate risk. In other words, parallel shifts of the yield curve. Price Risk and Re-investment Rate Risk balance offset eachother to an extent. For example, an increase in interest rates will reduce the price of the bond (increased price risk), but reduced re-investment risk because the coupon payments will be re-invested at a higher rate. Given that all bonds are faced with price risk, the best immunization strategy is to have bonds that minimize re-investment risk. Therefore, your best strategy is to use Zero Coupon bonds because there are no coupon payments and you match up the maturity to that of the liability maturity. The 2nd best option is using Bullets where you focus the cash flows to when the liability comes due. Always remember that Re-Investment Rate Risk for coupon bonds makes maturity matching an ineffective way of immunizing liabilities. Anyone else want to chime in? PJStyles
Thanks PJ, I can just review this with my notes and that should (hopefully) do it! Much appreciated! a.