Fixed income Portfolio management-Immunization

I have a related question. Conceptually, what’s the difference between ALM and immunization? ALM is matching the duration of a portfolio the duration of a liability, right? Isn’t that what immunization is? Thanks!

You are on the right track, though remember that the actual impact will depend to some extent on the structure of the liability.  If we are holding Bonds to maturity then the price change due to interest rate changes is kind of irrelevant (as the plan all along is for the Bond to mature <at par> so we can clear the debt.

For example: If the liability has a fixed  value (say $100), due to be paid at some point in the future (using previous example, let’s say at year 7) then it will be unaffected by changes in the interest rate, but the asset (Bond) will be affected if it has a maturity unequal to the 7 year of the liability.

Just to reiterate:
*immunisation is based on the assumption we are trying to perfectly offset $1 of liability at a certain date with $1 of asset at the same date.  
*Reinvestment risk only comes into the picture when there is a mismatch
*If the asset (say zero coupon Bond) has been matched to the liability so that the Bond maturing (at par) meets the liability, then interest rate changes should not adversely impact the strategy.

Use an example:  Let’s say the portfolio’s duration is 5.0 (holding a single Bond) and the liability duration is 7.0 (with a single liability).  In this case we might conclude that the Bond is due to mature in 5 years.  However as the liability isn’t due until end of year 7 we have 2 years to fill, so we are subject to the risk that we will be unable to achieve the required return from the Bond (invested for 2 years from end of year 5 to end year 7).  This is where reinvestment risk comes into play.

To extend the example, say that the liability is for $1m.  We set aside $710k in a Bond trading at YTM of 5%.  If this was held for 7 years it would offset the $1m.  However as we only secured a term of 5 years we can only be assured that at the end of the term (5 years) the Bond will mature at $907k.  If we can reinvest this into a new Bond for a term of 2 years paying 5% then we have successfully achieved a final value of $1m (and thus offset the liability).

On the other hand if interest rates fall and the YTM reduces to 4% for the 2-year Bond, the final value will be $981k, leaving us short $19k.  Of course rates could rise, in which case we could end up ahead (YTM of 6% for the 2-year Bond would produce $1,019k).

**just to add, in the example (for simplicity) we are talking a single liability with starting duration of 7.0.  Remember that as we get closer to the time payment is due or owed the duration will reduce (this goes for any asset or liability).  Therefore by the end of year 5 the liability will have a duration of around 2.0 etc etc… 

@sep123 – yep, pretty much.   😉

Sep123, immunization is a formal application of ALM to a fixed income context where you are matching the exact risk of a given fixed-income portfolio.

ALM is the broader framework.