What is contingent immunization?
A fund manager uses a contingent immunization if his investment approach involves switching to a defensive strategy once the portfolio returns decline lower than the predetermined point. The terms contingent or contingency may be familiar to you. In general, it refers to something that may happen, but there is no certainty. It is pretty similar to what we will talk about today: contingent immunization.
Contingency immunization refers to a contingency plan applied to specific fixed income portfolios. The fund manager utilizes an active management approach to selected securities. They hope that they can perform beyond the benchmark. On the other hand, the contingency plan gets triggered if a specific and predetermined loss accumulates. This plan will make the asset immune from further losses.
The classic immunization
If this sounds familiar to you, you may have already encountered the “classic immunization.” It might be familiar because contingent immunization is its extension. It is like a classic immunization combined with an active management approach. In this way, there is a chance of getting the best of both methods. But what is classic immunization? It means making a fixed-income portfolio that generates an assured return for a set time. The parallel shifts in the yield curve are not really crucial.
Tell me more about contingent immunization.
Let us say that the investment portfolio’s return declined to a predetermined level. The portfolio manager will let go of the usual active management approach and go with a contingency plan instead. This plan will immunize the assets from having more losses. What can one do to protect the remaining assets and secure a minimum return? One can buy high-quality assets with a low and stable income stream. In this way, the assets will match the liabilities. Hence, the underlying assets remain the same when the interest rate changes. While everything seems great and safe, you should know that it does not guarantee anything because there are still risks, especially regarding market timing.
A dedicated portfolio theory
People say that contingent immunization is a dedicated portfolio theory. What is that? One makes a dedicated portfolio using securities with a predictable income stream. For example, we have high-quality bonds. Usually, we hold on to assets until they mature because we want to make a predictable income that we can use to pay liabilities. Which strategy can help a portfolio with a single asset type? You can make long-term and short-term positions in line with the yield curve.
The cash matching strategy is the simplest of all immunization strategies. Investors buy zero-coupon bonds that match the amount and length of their liabilities. We also have a duration matching strategy, which is a more practical application. Here, the duration of assets is matched to that of the liabilities.
Something too restrictive
We also have a strict minimization approach, but some may find it too restrictive to make enough returns in some situations. A high-yielding portfolio might be a great option if there is a considerable increase in the expected return with minimal immunization risk effect. The cushion spread is the difference between the minimum acceptable performance and the higher probable immunized rate.
