|Course 104: Immunization|
|What Is Bond Immunization?|
Bond immunization is an investment strategy used to minimize the interest rate risk of bond investments by adjusting the portfolio duration to match the investor's investment time horizon. It does this by locking in a fixed rate of return during the amount of time an investor plans to keep the investment without cashing it in.
Immunization locks in a fixed rate of return during the amount of time an investor plans to keep the bond without cashing it in.
Normally, interest rates affect bond prices inversely. When interest rates go up, bond prices go down. But when a bond portfolio is immunized, the investor receives a specific rate of return over a given time period regardless of what happens to interest rates during that time. In other words, the bond is "immune" to fluctuating interest rates.
To immunize a bond portfolio, you need to know the duration of the bonds in the portfolio and adjust the portfolio so that the portfolio's duration equals the investment time horizon. For example, suppose you need to have $50,000 in five years for your child's education. You might decide to invest in bonds. You can immunize your bond portfolio by selecting bonds that will equal exactly $50,000 in five years regardless of interest rate changes. You can buy one zero-coupon bond that will mature in five years to equal $50,000, or several coupon bonds each with a five year duration, or several bonds that "average" a five-year duration.
Duration measures a bond's market risk and price volatility in response to a given change in interest rates. Duration is a weighted average of the bond's cash flows over its life. The weights are the present value of each interest payment as a percentage of the bond's full price. The longer the duration of a bond, the greater its price volatility. Duration is used to determine how a bond will react to changing interest rates. For example, if interest rates rise 1%, a bond with a two-year duration will fall about 2% in value.
You needn't worry about doing the calculations as you can obtain a bond's (or bond fund's) duration from a broker or advisor. Using bonds' durations, you can build a bond portfolio immune to interest rate risk.
Effects of Bond Immunization >>
Next: Effects of Bond Immunization >>
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