Bond portfolios have the same needs as stock portfolios when it comes to diversifying against risk. A common strategy used by professionals is known as “immunization.” In order to balance out bonds of various qualities, rates, and maturities, investment managers use immunization to hedge against changing interest rates. The mathematical calculations required to use this trading strategy are highly complex and ordinarily are only used by large firms with significant risk concerns.
Duration is the measure of price sensitivity of fixed income products to a change in interest rates. A general rule of thumb is that the longer the maturity of a bond, the higher its duration, or sensitivity to rate changes. A diversified portfolio includes bonds of differing maturity dates in order to bring the overall duration down to a manageable level, but may involve more complex strategies to drop it to zero.
Interest Rate Risk
Fixed income products such as bonds have an inverse relationship to interest rates. As rates rise, the price of a bond will fall. Thus, for a portfolio made up entirely of bonds, the impact rising rates have can be devastating. Immunization attempts to use options and various derivatives to create a scenario in which rising rates won't negatively impact the overall bond portfolio.
Drawbacks of Immunization
Due to the complexity of immunization methods, it is not always possible to bring interest rate risk and duration to zero without employing the use of derivative products that may ultimately subject a portfolio to other forms of risk. Bonds have many various qualities, such as creditworthiness and payment schedules, that also need to averaged out.
Bond's may have the reputation for being investments with low volatility, but they are still subject to risk. Immunization means balancing out risks associated with fixed income products, and creating a situation that will not cause a price drop when rates change. Professional money managers use immunization as part of their trading strategy to benefit consumers who may not have the knowledge to execute it on their own.
- Bond Portfolio Immunization; Michael R. Granito
- Getting Started in Fundamental Analysis; Michael C. Thomsett
Daniel Cross resides in Florida and has been writing investment and financial articles since 2005. He holds the Chartered Financial Consultant designation from the American College in Bryn Mawr, Pennsylvania.