Contingent immunisation lets a manager run an active bond portfolio for as long as the surplus over the immunising cost lasts, and forces a switch to a locked immunised build the moment it does not. Few fixed-income mandates carry a stop that is mechanical rather than discretionary, and this is the one a bond investor meets most often.
What three quantities define contingent immunization?
Three quantities define it.
The safety-net return is the minimum the client will accept over the horizon, always below the rate a fully immunised portfolio could lock in today. If the two were equal there would be no room to be active at all.
The required assets figure is the present value, at today's available immunisation rate, of the terminal amount the safety net promises. On $100 million over five years with a 4.00% floor and a 5.20% immunisation rate available, the safety net promises $121.665290 million at maturity, which requires $94.425218 million today.
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The cushion is the difference between the assets you have and the assets you need. Here it is $100.000000 million less $94.425218 million, or $5.574782 million, which is 5.574782% of the portfolio. The cushion is the entire budget for active risk, and it is not a constant: it moves whenever rates move, because the required-assets figure is a discounted quantity.
The trigger yield is the immunisation rate at which the cushion reaches zero. Above it the portfolio can no longer buy the safety net at any price, and the mandate requires an immediate switch. Worked Example 3 solves for it on an active book of 9.00 duration and 95 convexity and gets 6.584581%, which is 138.4581 basis points above today's 5.20%. A duration-only model puts it at 6.395996%, or 119.5996 basis points, and the difference between those two numbers is entirely the convexity of the active book.
How much room the cushion buys depends almost entirely on the active portfolio's duration, and the relationship is steep. On the duration-only model the same $5.574782 million cushion supports 508.59 basis points of room at an active duration of 5.00, 202.02 at 7.00, 119.60 at 9.00, 73.31 at 12.00 and 52.70 at 15.00. A manager who lengthens duration to express a rate view is spending cushion, and a manager who lengthens it after the cushion has already shrunk is spending money that is not there.
What happens if the manager does not act?
The failure mode is a manager who watches the cushion and does not act. In Worked Example 3 rates reach 7.20%, the portfolio is worth $83.900000 million against $85.939490 million required, and the safety net can no longer be bought. What is lockable at 7.20% is $118.777967 million against the $121.665290 million promised, a shortfall of $2.887323 million, and the client receives 3.501627% a year against the 4.00% floor written into the contract. The strategy did not fail. The stop did.
A workable programme therefore recomputes the cushion and the trigger yield at least weekly, and after any move of more than about 25 basis points regardless of the calendar. Both quantities move with rates and with the portfolio at the same time, so last quarter's figure does more than age. It describes a portfolio the plan no longer holds, facing a curve the market no longer shows.