Owning Bonds

Matching Strategies

Matching strategies are used to create a bond portfolio that will finance specific funding needs, such as education, a down payment on a second home, or retirement. If the timing and cash flow amounts of these needs can be predicted, then a matching strategy can be used to support them. This strategy involves matching a "liability" (to yourself, because you "owe" yourself the chance to reach that goal) with an asset, a bond investment. The two most commonly used matching strategies are immunization and cash flow matching.

Immunization is designing a bond portfolio that will achieve a certain rate of return over a specific period of time, based on the idea of balancing interest rate risk and reinvestment risk.

Recall that as interest rates rise, bond values decrease, but reinvested income from bond coupons earns more. As interest rates fall, bond values increase, but reinvested income from bond coupons decreases. Immunization is the idea of choosing a portfolio of bonds such that the exposure to interest rate risk is exactly offset by the exposure to reinvestment risk for a certain period of time, thus guaranteeing a minimum return over that period.

In other words, the interest rate risk and the reinvestment risk cancel each other out, and the investor is left with a guaranteed return. You would use this kind of strategy when you had a liquidity need with a deadline, for example, to fund a child's higher education.

Cash flow matching, also called a dedication strategy, is an alternative to immunization. It involves choosing bonds that match your anticipated cash flow needs by having maturities that coincide with the timing of those needs. For example, if you will need $50,000 for travel in twenty years, you could buy bonds with a face value of $50,000 and a maturity of twenty years. If you hold the bonds to maturity, their face value provides the amount of cash flow you need, and you don't have to worry about interest rate or reinvestment risk. You can plan on having $50,000 in twenty years, barring any default.

If you had the $50,000 now, you could just stuff it under your mattress or save it in a savings account. But buying a bond has two advantages: (1) you may be able to buy the bond for less than $50,000 now, requiring less upfront investment and (2) over the next twenty years, the bond will also pay coupons at a higher rate than you could earn with a savings account or under your mattress.

If you will need different cash flows at different times, you can use cash flow matching for each one. When cash flow matching is used to create a steady stream of regular cash flows, it is called bond laddering. You invest in bonds of different maturities, such that you would have one bond maturing and providing cash flow in each period (like the CD laddering discussed in Chapter 7 "Financial Management".

Strategies such as immunization and cash flow matching are designed to manage interest rate and reinvestment risk to minimize their effects on your portfolio's goals. Since you are pursuing an active strategy by selecting individual bonds, you must also consider transaction costs and the tax consequences of your gain (or loss) at maturity and their effects on your target cash flows.