Fixed-income instruments like bonds are directly prone to interest rate risks. Bond prices move inversely with interest rate movements. Thus, the investment portfolio of an investor or a company can be affected due to a change in interest rate changes. Duration matching is a strategy to counter interest rate risks.
Investors can use the duration matching strategy to match the assets (cash inflows) with liabilities (cash outflows) to minimize the interest rate risks. However, finding ideal instruments to exactly match the cash inflows and outflows is difficult.
Deeper Definition
Duration matching is a strategy that uses matching cash inflows from an asset to outflows arising from liabilities.
Individuals can implement a duration matching strategy to reduce interest rate effects on their investment portfolios. Businesses can also use it to protect their net assets against interest rate movements.
Under the duration matching strategy, assets or investments are chosen based on the risk profile and cash flow requirements. Thus, the anticipated returns on investments are matched against liabilities payments at the same time intervals.
How Does Duration Matching Work?
Duration matching involves finding suitable fixed-income instruments that provide cash flows to match against the liability cash outflows, such as for a loan. It involves matching exact assets and liabilities for the same durations.
Individuals and businesses can use the duration matching strategies to protect themselves against adverse interest rate movements. Fixed-income securities such as bonds move inversely to interest rate movements. Thus, a decrease in assets is naturally offset against an increase in liabilities. Duration matching tries to bridge this gap by adjusting cash flows to minimize the interest rate movement effects.
The effectiveness of the duration matching strategy will be based on finding the exact investments against liabilities such as loans. For instance, a fixed-income instrument, such as a bond, is considered an ideal instrument for duration matching.
Investors would consider all the coupon payments and principal repayment and match the total cash inflows against the payment requirements. In addition, they will need to consider the maturity, interest rate, and amount of the bond so that it fulfills their exact cash flow requirements in the future.
Working Example
Let us understand the concept of duration matching with a simple working example.
| Time | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 |
|---|---|---|---|---|---|
| Loan Payment | 5,000 | 6,000 | 8,000 | 11,000 | 15,000 |
| Principal Payment | 2,400 | 3,400 | 6,200 | 9,500 | 14,000 |
| Cash flow | 1,000 | 1,000 | 1,000 | 1,000 | 1,000 |
| Cash flow | 500 | 500 | 500 | 500 | 0 |
| Cash flow | 300 | 300 | 300 | 0 | 0 |
| Cash flow | 800 | 800 | 0 | 0 | 0 |
| Total | 5,000 | 6,000 | 8,000 | 11,000 | 15,000 |
Suppose the firm needs to pay five loan payments as shown above in the first row of the table. To fund these liability payments, the firm can find five different coupon bonds to match the cash flows.
First, we find a bond with a face value of $14,000 and a coupon payment of $1,000 with a 5-year maturity. It satisfies the final loan payment. Next, we find a bond with a face value of $ 9,500, maturity of 4 years, and coupon payments of $500. Continuing the same way, we find a zero-coupon bond with a one-year maturity and face value of $2,400. By matching the duration of these coupons and principal payments, we can match the loan payments for the next five years.
Special Considerations with Duration Matching
Let’s continue with our example above, we can see finding five different bonds with different coupon rates will be a challenging task. Also, the coupon rates on all of these bonds will be prone to interest rate risks. Hence, an adverse movement in interest rate would require a rebalancing of the portfolio again.
Also, the interest rate charged by creditors depends on the credit profile of the applicant. Thus, the interest rate on liabilities can drastically change if the business or an individual cannot maintain the credit score.
Cash flow balancing for duration matching strategies also requires investing and reinvesting any excess cash flows. Thus, it’s a challenging task to achieve practically.
Pros and Cons of Duration Matching Strategy
Pros Explained
Duration matching is an effective strategy that individuals and firms can use to match liability payments through investments. In addition, it can help individuals and firms protect their assets against adverse movements in interest rates.
Cons Explained
Duration matching would require substantial efforts to find suitable fixed-income instruments. In practice, matching the cash flows from a bond with a loan payment for the exact amounts is difficult. The excessive cash flows would also need to be reinvested to match the liability payments.
Final Thoughts
Duration matching is an effective but difficult strategy against interest rate risk hedging. However, if individuals or businesses can execute it properly, they can immune their assets against adverse movements in interest rates.
