Read the article provided below, note it was published in 1986. This article discussed a strategy on bond immunization. Provide your thoughts on the article, specifically do these strategies still make sense in today’s market. Comment on one potential advantage and one potential disadvantage of the strategy.
YOUR MONEY; Bond Strategy Locks in Yields
By Leonard Sloane
July 19, 1986
THE current era of low interest rates – and wide-scale expectations of a continuation of this trend – has focused attention on an investment strategy known as bond immunization.
Long used by pension plans and now being utilized by a growing number of individuals, bond immunization is the matching of bond maturities in income streams in accordance with an investor’s needs. The strategy, which locks in a yield, is designed to produce a defined set of benefits regardless of periodic interest rate fluctuations.
”What it means is immunizing your bond portfolio to your particular expectations for whatever time frame you have in mind,” said R. Sean Lapp, director of futures and options of Boston Security Counselors. ”The objectives of immunization are to satisfy liabilities, reduce systematic risk and assure an aceptable rate of return. It insulates your assets from market risk as much as possible.”
Leonard H. Wissner, chairman of Ward & Wissner Capital Management, a New York money management concern, said: ”The idea of immunity is to remove uncertainty. It provides the certainty that one would be able to meet obligations whether interest rates rise or fall in the future. Obligations or liabilities of the investor can be guaranteed independent of any external factors in the investment environment.”
Mr. Wissner gave the example of a family with a newborn child that estimates a need for $12,500 a year for four years – or a total of $50,000 – to pay for the child’s college education. It might then purchase four zero coupon Treasury bonds that mature in 18, 19, 20 and 21 years, respectively.
A zero coupon bond makes no periodic interest payments, but is instead sold at a deep discount from face value. The cost of these four bonds, based on a compounded interest rate for such securities of 8.1 percent, would amount to $10,672.
However, by locking in this 8.1 percent rate, the family could be exposed to an adverse situation if inflation and interest rates were to rise during this period to, say, 12 percent. So an even more conservative approach might be to buy shorter-term Treasury bonds and thereby have the opportunity to reinvest at a higher rate. That higher rate would offset the likely higher college costs due to the greater inflation.
On the other hand, if inflation and interest rates decline in the years ahead, the family would be forced to reinvest at a lower rate. But college expenses would also probably not rise as fast as originally expected and the required outlay would therefore be lower.
Despite the apparent attractiveness of bond immunization, it has another major disadvantage besides the lack of liquidity. For the debt instruments in the portfolio carry a large opportunity cost – a measurement of the projected return against the return that could be earned from the highest-yielding alternative investment – because of the long-term maturity structure. The longer the term of the investment, the greater the opportunity cost.
To minimize such opportunity costs, as well as to further insulate the bond portfolio from fluctuations in the value of the principal, the systematic application of financial options and futures can be used as a part of the bond immunization process. These more speculative devices designed to bolster net returns might be particularly appropriate for higher net worth individuals.
For instance, the holder of a bond portfolio could write a Treasury bond call – or option to buy at a specified price within a specified time – against the portfolio. The price this holder got for selling the call, as determined by market supply and demand forces, might then offset the volatility risk if interest rates rise and the value of the portfolio declines.
”Options and futures add quantum efficiency to your portfolio,” said Mr. Lapp, whose company is a subsidiary of Advest Inc., a securities firm based in Boston. ”The premium received compensates the individual for contracting to sell his bonds. Since he had these obligations to begin with, the premium increased total return and reduced risk.”
Take the case of a person with a bond portfolio of $500,000 who expects that prices of the bonds in the portfolio could go up or down by a maximum of 12 percent a year. The maximum decline in the portfolio for the year is thus likely to be no more than $60,000, according to this scenario. Mr. Lapp said that, by writing calls on the $500,000 in bonds, the annualized premium, or price received from the buyer of the calls, would be about $46,000, narrowing the potential loss in market value to $14,000.
Another technique in bond immunization might be the use of the newly developed futures contracts based on the Consumer Price Index and traded on the New York Futures Exchange. But some experts in this field believe that those contracts have not yet built sufficient liquidity and should be avoided until they do.
”The most important rule is to set a yield objective that is realizable and that you can get comfortable with,” Mr. Lapp said. ”What you shouldn’t do is guess market direction. Remember that, the longer the maturity, the longer the yield and the higher the principal risk. And let your portfolio do what it’s supposed to do.”