Effects of Bond Immunization

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Effects of Bond Immunization

Changes to interest rates actually affect two parts of a bond’s value on the market. One of them is a change in the bond’s price, or price effect. When interest rates change before the bond matures, the bond’s final value changes, too. An increase in interest rates means new bond issues offer higher earnings, so the prices of older bonds decline on the secondary market.

How reinvestment risk is affected

Interest rate fluctuations also affect a bond’s reinvestment risk. When interest rates rise, a bond’s coupon may be reinvested at a higher rate. When they decrease, bond coupons can only be reinvested at the new, lower rates.

Interest rate changes have opposite effects on a bond’s price and reinvestment opportunities. While an increase in rates hurts a bond’s price, it helps the bond’s reinvestment rate. The goal of immunization is to offset these two changes to an investor’s bond value, leaving its worth unchanged.

The final result of immunization

A portfolio is immunized when its duration equals the investor’s time horizon. At this point, any changes to interest rates will affect both price and reinvestment at the same rate, keeping the portfolio’s rate of return the same. Maintaining an immunized portfolio means rebalancing the portfolio’s average duration every time interest rates change, so that the average duration continues to equal the investor’s time horizon.

"Dedicating"

A more direct form of immunization, "dedicating" a portfolio not only matches its duration to the investor’s long-term time horizon, but also matches specific anticipated receipts of cash to the investor’s specific anticipated liabilities along the way. To pay for college, for example, a parent might construct a bond portfolio so that interest and principal payments will be paid each year in September, when tuition is due.