Immunization

[hei.so]

“investing in a bond portfolio with a yield to maturity equal to the target yield and a maturity equal to the investment horizon does not assure that the target value will be achieved because of reinvestment risk.”
So are you supposed to invest in a bond portfolio that has a greater YTM than the target yield to lessen reinvestment risk?

 

[ov25]

you are supposed to cashflow match for reinvestment risk=0 or buy zero-coupon bonds that mature @ horizon

 

[S2000magician]

ov25 wrote:you are supposed to cashflow match for reinvestment risk=0 or buy zero-coupon bonds that mature @ horizon

Um … no you’re not.
This is generally a very inefficient method.

 

[S2000magician]

hei.so wrote:”investing in a bond portfolio with a yield to maturity equal to the target yield and a maturity equal to the investment horizon does not assure that the target value will be achieved because of reinvestment risk.”
So are you supposed to invest in a bond portfolio that has a greater YTM than the target yield to lessen reinvestment risk?

With a normal yield curve, your reinvestment rate will be less than your YTM, so your realized yield will be less than your YTM. (You may recall this from Level I; it’s one of the shortcomings of IRR.)
If you want your realized yield to be sufficient to cover your liabilities, then if the yield curve is normal (i.e., upward-sloping), you’ll need to invest in a portfolio whose YTM is higher than your required rate of return.

 

[hei.so]

S2000magician wrote:
With a normal yield curve, your reinvestment rate will be less than your YTM, so your realized yield will be less than your YTM. (You may recall this from Level I; it’s one of the shortcomings of IRR.)

I don’t remember Level 1 and fixed income is my worst topic… Why is reinvestment rate less than YTM? Because you can’t reinvest coupon rates at the YTM?

 

[cpk123]

normal yield curve is UPWARD sloping.
So if you had a 5 year bond - when it becomes a 4 year bond - the rate you reinvest will be lower than what the coupons could be reinvested if it were a 5 year bond.
the YTM is assuming the flat 5 year rate is available all through.