Bond duration and Portfolio immunization

Bond duration and Portfolio immunization

Bond is one most popularly used fixed income security for the investors. It provides fixed coupon interest over its life. However, these types of securities face three common types of price risk; credit risk, interest rate risk, and reinvestment rate risk. Credit risk, also called default risk, is the likelihood that a borrower will be unable or unwilling to repay a loan as agreed time schedule. The two other sources of risk arise from the change in the general market interest rate over the life of the bond

Market interest rate is the opportunity rate of return (i.e. discount rate) for the investors thus changes in the market interest rate inversely change the present value of bond i.e. the selling price of the bond. The most widely used technique to measure the bond’s interest rate risk is the duration.

Another type of risk associated is reinvestment rate risk which is the uncertainty associated with the rate at which the coupon payment reinvested as it received.

Increase in the market interest rate decline the price of the bond but raise the total return from the reinvestment and vice-versa. The time period at which these two exactly offset one another is measured by the duration. Thus duration is the point of time at which the investors able to earn yield to maturity.

Bond’s yield to maturity is that rate of return, which equal present value bonds cash flow to the current market price. This suggests that the investor should earn yield to maturity rate.

Determination of bond duration

A bond’s duration may be define as the weighted average numbers of years until the cash flows occurs, with the relative present values of each cash flow used as the weights. It can be expressed as;

Bond’s Duration (D) = or

Bond immunization

The term immunization refers to giving protection against some kinds of diseases. The bond immunization implies giving protection to the investor(s) of bond against the risk associated with bond that is price risk. The bond can be immunized matching the duration. As we explained earlier duration is the point of time at which bond’s interest rate risk and reinvestment risk exactly offset one another and the investor able to earn anticipated rate of yield to maturity (YTM) in desire investment horizon.

Thus, the essence of immunization is the matching the duration with desire holding period by balancing between interest rate risk and reinvestment risk.

In duration matching immunization technique, the investor(s) selects the bonds having required duration and hold until the duration only and sold doing so, the investors immunize the impact of interest rate and able to earn anticipated rate of return.