Immunization Strategies for Bond Portfolios

What Is Immunization?

Immunization is a strategy that protects a portfolio against interest rate changes by matching the duration of assets and liabilities. If assets and liabilities have the same present value and the same duration, a small parallel shift in the yield curve will not create a surplus deficit. The portfolio is "immunized" against small rate changes.

Redington immunization requires three conditions: (1) PV(assets) = PV(liabilities), (2) Duration(assets) = Duration(liabilities), (3) Convexity(assets) > Convexity(liabilities). The third condition ensures that the asset value increases more than liability value for any rate change, creating a surplus.

Implementing Immunization

To immunize a single liability due at time T, invest in two assets with durations D1 < T < D2. Choose weights w1 and w2 such that w1*D1 + w2*D2 = T and w1 + w2 = 1. The present value of assets must equal the present value of the liability. The convexity condition is automatically satisfied when asset cash flows are more spread out than the liability.

Example: To immunize a liability due in 5 years, use a 2-year zero and a 10-year zero. Weights: w1*2 + w2*10 = 5 with w1 + w2 = 1, giving w1 = 5/8 and w2 = 3/8.

Limitations

Immunization protects against small, parallel yield curve shifts only. It must be rebalanced as time passes and rates change. Non-parallel shifts (changes in the shape of the yield curve) can still affect the portfolio. Full immunization (also called dedication or exact matching) eliminates interest rate risk entirely by cash-flow matching each liability with an asset, but this is more expensive than Redington immunization.