Contingent Immunization

What Is 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, a contingency plan is triggered once certain predetermined losses have accumulated. The idea is that the contingency plan will immunize assets against further losses.

Contingent immunization is an extension of classic immunization, blending the latter with an active management approach, hopefully capturing the advantages of both. 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.

How Contingent Immunization Works

When an investment portfolio's returns drop to a predetermined level, the portfolio manager forgoes the typical active management approach and implements a contingency plan. This plan is intended to immunize the assets against further losses. 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.

Although contingent immunization sounds safe, it introduces some new risks related to market timing.

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. One approach is to create long-term and short-term positions along the yield curve. This strategy 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 minimum acceptable performance and the higher possible immunized rate is known as the cushion spread.

Advantages of Contingent Immunization

The main advantage of contingent immunization is that it limits tracking risk. For example, a bond fund manager may have the ability to invest in junk bonds or take an overweight position in long-term government bonds. That gives the fund manager the ability to beat the bond market, but it can also lead to underperformance. Every manager has good years and bad years. Contingent immunization limits the losses from bad years by forcing the manager to return to a safer position after losses.

In theory, contingent immunization allows the good times to roll while cutting losses. If a fund manager just keeps winning, investors in the fund can substantially beat the market. On the other hand, contingent immunization acts somewhat like a stop-loss order when the manager is underperforming.

Disadvantages of Contingent Immunization

It can be argued that contingent immunization is just another form of market timing, and it suffers from the same drawbacks. Rather than limiting losses, contingent immunization can lock them in.

Suppose that a fund manager anticipates that the Federal Reserve (Fed) is going to end a round of interest rate hikes. The manager then takes up a substantial position in long-term government bonds in an attempt to profit. If the Fed raises rates just one more time, long-term Treasury prices will go down instead of up. The fund manager could be pushed out of the position in long-term government bonds by contingent immunization. Since it was the last interest rate increase, Treasury prices will start going up soon after that. Contingent immunization will then force the unfortunate fund manager to sit on the sidelines.