Assume we trigger an immunization strategy after losing the spread cushion should interest rates move against us. what does this mean in practical terms ? we abandon active management but do we then switch into zero’s or adopt a passive management strategy and invest in pure bond index using optimization techniques ? Either way, aren’t we adding to transaction costs with a rebalancing of the remainder of the portfolio and eroding the return? Can someone provide a simple explanation ?
An contingent immunization strategy is designed to take advantage of active management, but only above the required immunization level. Once your cushion spread is gone, you immediately switch to the immunization strategy to lock in the minimal acceptable return (called safety net return). You’re not worried about the transaction costs at this point, what you’re concerned with is the possibility that you might no longer be able to meet your liabilities. The cost of immunization is that you’re giving up potentially higher E®’s. The lower E® of an immunized strategy means that it will require more funds to generate the same outcome, but it has a greater certainty of reaching that outcome (paying liabilities).
Thanks McLeod, so once the cushion is gone we just stick with the remaining portfolio of bonds that we set up at the outset? In other words if its immunized we’re assuming the remaining bond portfolio will match liability requirements more or less ?
Not necessarily. The process doesn’t require the segmenting of portfolio between active and immunized portions. The entire portfolio is generally going to be managed actively until the trigger is hit. At that point, adjustments would be made to the existing portfolio so that it is immunized. Even if you did have a separate immunized portfolio, whatever caused your bonds to fall below the minimal required level probably also would have thrown any immunization out of whack as well. So rebalancing would still be necessary.
my understanding is that when the immunization strategy is triggered we move into a passive/indexing strategy. the strategy is formulated such that the portfolio assets are able to generate the minimum accepted return. you make a good point about transaction costs. not sure how these get factored in.
i think when immunization is triggered, you move to whatever the immunized strategy is (passive/indexing or some enhanced variety). “In other words if its immunized we’re assuming the remaining bond portfolio will match liability requirements more or less ?” Yep, when your active strategy falls out of bed, you have to scramble to get the best return you can and this is immunized. Think of a really bad bond manager having screwed up so completely that he has to buy zeroes to meet the horizon. The amount at horizon may not be optimal (i.e. meet the need) but it removes screw-up risk from the equation.
So rebalancing is sure to take place and with some added transactions costs as a result.