In this lesson, you will learn a bond portfolio management technique known as immunization. This technique is very useful in asset-liability management, a problem that affects pension funds, insurance companies, and banks.
For example, consider a pension fund. The fund has assets (retirement contributions paid into the fund) and liabilities (promised pension payment, typically either lump sum payments or annuities). The contributions are typically invested in bonds. The fund has to ensure that the assets are sufficient to cover liabilities. An insurance company typically sells interest rate sensitive contracts such as whole-life policies and annuities. Banks typically have short-term liabilities (for example, deposits and certificates of deposit) and long-term assets (loans).
There are two basic approaches that are followed in asset liability management. The first is called “dedication.” In this approach, the assets are invested in bonds so that the cash inflows generated by these bonds match as closely as possible the cash outflows of the liability, so assets and liabilities are matched at the cash flow level. This is described later, under “Bond Portfolio Dedication.”
Another approach is called “immunization.” In this approach, we match assets and liability values. This is useful if we cannot exactly match the cash flows of the assets and liabilities. The idea is that if we can ensure that the value of the assets always exceeds the value of the liabilities, then we can always sell some of the assets to meet the cash outflows. Since we don’t match the cash flows, we face the risk that interest rates will change in a way that leads the assets to be worth less than the liabilities, in which case the pension fund is “under-funded.” What is important here is to measure accurately how asset and liability values change when interest rates change, and you will see different approaches that have emerged.
Click NEXT to see an example of an under-funded pension fund.