Learning Outcomes
This article explains how credit risk interacts with yield curve strategies in fixed income portfolio management. It defines credit risk, duration, convexity, immunization, liability-driven investing (LDI), cash-flow matching, and immunization risk, and shows how these concepts are applied to construct portfolios that reliably meet future liabilities. The article describes classic single-liability and multiple-liability immunization, highlighting the conditions required for successful immunization and the implications of parallel versus non-parallel yield curve shifts. It discusses how duration and convexity matching can be used to reduce interest rate risk, and why non-parallel shifts, embedded options, and default risk can cause immunization failure. It examines core LDI techniques—cash-flow matching, duration/contribution matching, and hedging with derivatives—and contrasts their costs, benefits, and practical limitations. The article also analyzes key implementation risks, including credit deterioration, model error, transaction costs, and liquidity constraints, and emphasizes the need for monitoring and rebalancing. Overall, it provides a structured framework for evaluating when immunization or LDI is most appropriate for meeting liability-driven objectives in exam-style scenarios.
CFA Level 2 Syllabus
For the CFA Level 2 exam, you are expected to understand how credit risk interacts with portfolio strategies, with a focus on the following syllabus points:
- Applying duration and convexity to match asset and liability cash flows.
- Explaining the objectives and mechanics of immunization and LDI.
- Identifying how parallel and non-parallel yield curve shifts affect immunized portfolios.
- Assessing the impact of credit and yield curve risks on immunization success.
- Evaluating the sources and costs of credit risk in fixed income strategies.
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- What is the main objective of immunization in fixed income portfolio management?
- A pension fund wants to ensure it can meet future liabilities regardless of interest rate movements. Which portfolio technique is most appropriate?
- How does a non-parallel shift in the yield curve threaten an immunized portfolio?
- What is liability-driven investing (LDI) and for what types of investors is it especially suitable?
Introduction
Credit risk and yield curve strategies are central to managing fixed income portfolios. Investors face the challenge of balancing returns with the risk of both changing interest rates and borrower defaults. Immunization and liability-driven investing (LDI) are two critical approaches to ensure that future liabilities can be reliably met while maintaining appropriate risk controls.
Key Term: credit risk
The risk of loss if a bond issuer or counterparty fails to meet contractual payments.Key Term: immunization
A portfolio strategy seeking to construct an asset portfolio whose value will be sufficient to meet a stream of future liabilities, regardless of interest rate changes.Key Term: liability-driven investing (LDI)
An approach that organizes an investment portfolio to specifically match and fund a stream of liabilities, focusing on minimizing shortfall risk.
Yield Curve Strategies: Duration, Immunization, and LDI
Managing credit risk within yield curve strategies requires careful consideration of both asset and liability profiles.
Duration and Convexity Matching
Immunization relies fundamentally on matching the duration of assets and liabilities. Duration measures the sensitivity of a bond’s price to small changes in interest rates:
Key Term: duration
The weighted average time until a bond’s cash flows are received, serving as a measure of price sensitivity to changes in interest rates.
To immunize a single liability, the portfolio duration must equal the time to that liability, and portfolio value must match the present value of the liability.
Key Term: convexity
The degree to which duration changes as yields change; higher convexity increases the accuracy of price sensitivity estimates for larger yield shifts.
Immunization: Theory and Practice
The goal of immunization is to lock in a portfolio return that will guarantee funding for a specified liability, even as interest rates fluctuate.
- Classic Single Liability Immunization: Construct an asset portfolio with a present value equal to the liability and a duration matching the liability's horizon.
- Multiple Liability Immunization: Requires matching both the present value and duration, and ensuring that the asset portfolio’s cash flows are adequate in every liability period. This is more complex and exposes the portfolio—when poorly designed—to immunization risk if rates change unevenly across the yield curve.
Key Term: immunization risk
The risk that the immunized portfolio value falls below the liability value due to assumptions breakdown or non-parallel yield curve shifts.
Worked Example 1.1
A pension fund owes a liability of $10 million in exactly 7 years. The fund’s investment manager builds a bond portfolio with a market value of $10 million and a portfolio duration of 7 years. Interest rates fall sharply just after the portfolio is constructed. At the end of 7 years, the market value of the bonds exactly covers the liability.
Answer:
Because the fund duration matched the liability, and changes in interest rates affected both the present value of the liability and the investment portfolio equally, the liability was fully funded as planned.
Yield Curve Risk and Non-Parallel Shifts
Immunization is strictly effective only for parallel shifts in the yield curve—the scenario where all maturities’ yields move by the same amount. If the yield curve twists or bends (non-parallel shift), mismatches can arise between asset and liability values even if average duration is matched. Higher convexity in the asset portfolio can help, but does not eliminate this risk completely.
Worked Example 1.2
Suppose a bank immunizes a liability using a laddered government bond portfolio, exactly matching the present value and duration. Following a non-parallel shift—short-term yields drop while long-term yields rise—some bonds increase in value, others decrease. At the target date, the bank discovers its asset value now falls short of the liability payment.
Answer:
Non-parallel yield curve shifts caused the durations of assets and liabilities to respond differently, exposing the gap referred to as immunization risk.
Exam Warning
Immunization is not fail-safe. The strategy assumes no default, parallel shifts in the yield curve, and no interim cash flow mismatches. Pay close attention to whether test questions mention non-parallel yield curve movements, embedded options, or default risk—these weaken or may invalidate classic immunization.
Liability-Driven Investing (LDI)
Rather than focusing on outperforming a benchmark or maximizing return, LDI begins with the cash flows and timing of liabilities, and constructs or adjusts the asset portfolio to minimize the risk of being underfunded. LDI is widely used by pension funds, insurance companies, and endowments that must fund known liabilities at known or uncertain future dates.
Key LDI approaches include:
- Cash-flow matching: Invest in bonds with principal and coupon cash flows exactly matching liability payments.
- Duration/contribution matching: Adjust asset allocation so that duration and present value of assets meet those of liabilities.
- Hedging with derivatives: Use swaps, futures, or options to transfer or hedge unwanted interest rate or credit exposures.
Key Term: cash flow matching
An LDI technique in which the timing and amount of asset cash flows are structured to coincide exactly with liability payments.
Worked Example 1.3
A life insurer has $2 million in guaranteed annuity payouts due each year for the next eight years. The insurer builds a bond portfolio where the coupon and principal payments correspond in amount and timing to each year’s liability payment, using high-quality credit to minimize default risk.
Answer:
This is a textbook cash flow matching strategy, a form of LDI. No reinvestment risk exists if all coupon and principal cash flows precisely cover liabilities.
Risks and Limitations in Credit Risk and Immunization
- Default (Credit) Risk: Immunization and LDI strategies are undermined if asset credit quality deteriorates or issuers default. High-grade bonds or government securities are typically preferred for immunization.
- Yield Curve Reshaping: Immunization assumes parallel yield curve shifts; real-world twists, bends, and non-parallel changes may create funding shortfalls.
- Transaction and Model Risk: Portfolio rebalancing is needed after large interest rate moves or material liability revisions. Changes in market conditions, transaction costs, and unmodeled cash flow mismatches can compromise immunization.
- Liquidity Risk: Asset sales may be costly if the portfolio must be liquidated unfavorably.
- Cost Considerations: Cash flow matching typically requires greater capital and lower yield than duration matching or LDI using swaps or futures.
Revision Tip
Immunization requires frequent monitoring and potential rebalancing—especially if there are large moves in interest rates, yield curve shapes, or liability cash flows.
Summary
Immunization and LDI are essential tools for credit risk and yield curve strategy. Immunization sets out to ensure future liabilities can be met regardless of interest rate changes, but is most effective against parallel yield shifts and with assets free from default risk. LDI further tailors the investment process to meet actual liability needs directly, with cash-flow matching and derivatives-based strategies offering alternatives for implementation. Credit risk, liquidity, non-parallel yield curve risk, and tactical errors can erode the effectiveness of these strategies.
Key Point Checklist
This article has covered the following key knowledge points:
- Credit risk is the risk of issuer default and must be controlled in portfolio strategies.
- Immunization creates an asset portfolio matching present value and duration of liabilities.
- Immunization protects only against parallel yield curve shifts and default-free environments.
- Non-parallel shifts and default risk can cause immunization failure (immunization risk).
- LDI structures asset portfolios to specifically match the timing and amount of future liabilities.
- Cash flow matching eliminates reinvestment risk but may lower expected returns.
- Both immunization and LDI require periodic rebalancing and careful monitoring for changes in liabilities and market conditions.
Key Terms and Concepts
- credit risk
- immunization
- liability-driven investing (LDI)
- duration
- convexity
- immunization risk
- cash flow matching