Contingent Immunization—Part II: Problem Areas

Part I of this article, in the November/December 1982 issue of Financial Analysts Journal, explained the concept of Contingent Immunization and gave the procedures used to monitor a Contingent Immunization program over time so as to control the risks associated with movements in the yield curve. In essence, Contingent Immunization allows a bond portfolio manager to pursue the highest yields available through active strategies while relying on the techniques of bond immunization to assure that the portfolio will achieve a given minimal return over the investment horizon.

The difference between this minimal, or floor, rate of return and the maximum possible market rate is termed the cushion spread. Yield movements favorable to the manager’s active strategies will enlarge the cushion spread, increasing portfolio return. Adverse yield movements will erode the cushion spread. For any given portfolio, investment horizon and yield curve shape there will be a set of “trigger yield contours” that will determine at what yield levels the portfolio manager must begin to immunize the portfolio if he wishes to insure the floor return.

Contingent Immunization seems to offer the best of both worlds—the pursuit of maximum returns through active management and the limitation of downside risk through immunization. Yet Contingent Immunization is a complex and relatively new procedure. Part II of the article examines some of the factors that may create problems for Contingent Immunization, assesses their potential magnitude and offers some methods for ameliorating their effects. Finally, it provides an overall view of Contingent Immunization in terms of its position in the continuum from pure immunization to purely active bond management.