Contingent Immunization

Contingent immunization is an investment approach where a fund manager switches to a defensive strategy if the portfolio return drops below a predetermined point.

Contingent immunization typically refers to a contingency plan used in some fixed-income portfolios. It is a strategy where a fund manager uses an active management approach to individually select securities in hopes of outperforming a benchmark. However, once certain predetermined losses have accumulated, the contingency plan is triggered, hopefully immunizing the assets against further losses. Low-risk investment-grade securities are purchased, in this case to ensure a base level of return, though in some cases to match assets to liabilities.

Classic immunization can be defined as the creation of a fixed-income portfolio that produces an assured return for a set period, regardless of parallel shifts in the yield curve. Contingent immunization is an extension of classic immunization, blending the latter with an active management approach, hopefully capturing the advantages of both.

When an investment portfolio’s returns drop to a predetermined level, the portfolio manager forgoes the normal active management approach and implements a contingency plan intended to immunize the assets against further loss. High-quality assets with a low, but stable, income stream are purchased to protect the remaining assets and lock in a minimum return. Ideally, the assets purchased match up with any liabilities, leaving the underlying assets unchanged in the event of interest-rate changes.

One approach it to create long and short positions along the yield curve. This is useful for a portfolio of a single asset type, such as government bonds.

The simplest form of an immunization strategy is cash matching, where an investor buys zero-coupon bonds matching the amount and length of its liabilities. A more practical application would be a duration-matching strategy. In this scenario, the duration of assets is matched to the duration of liabilities.

A strict risk-minimization approach may be too restrictive to create an adequate return in certain situations. If a substantial increase to the expected return can be accomplished with little effect on immunization risk, the higher-yielding portfolio is often preferred. The difference between the minimal acceptable return and the higher possible immunized rate is known as the cushion spread.

Contingent immunization is a form of dedicated portfolio theory. It involves constructing a dedicated portfolio built using securities with a predictable income stream, such as high-quality bonds. Assets are often held to maturity to generate a predictable income to pay liabilities. The simplest form is known as a cash-matching strategy.