A life insurer's $14 billion bond portfolio is engineered so a 75-bps rate move shifts assets and liabilities by nearly the same amount. One careless rebalancing trade that extends asset duration by six months turns a well-hedged balance sheet into a $200 million directional bet.
Diversification: high-quality government bonds exhibit negative or low correlation with equities during stress. The benefit depends on credit quality. Investment-grade governments diversify effectively. High-yield corporates correlate with equities during downturns, providing little protection when you need it most.
Income generation: coupon income is more stable and predictable than equity dividends. Essential for portfolios funding regular distributions.
Inflation hedging: requires specific instruments. Nominal bonds lose real value when inflation rises. Governments issue inflation-linked bonds to give long-horizon savers a real-yield instrument that survives unexpected inflation. Inflation-linked bonds (TIPS, UK linkers) adjust principal and coupons for realized inflation. The hedge is imperfect because breakeven inflation embeds a liquidity premium and a risk premium.
Liability matching: aligns asset cash flows or durations with known obligations. DB pensions, life insurers, and banks use fixed income specifically to hedge liability risk.
Common mistakes
- Assuming all bonds provide diversification. Government bonds diversify equity risk. High-yield corporates behave like equity during stress, correlations spike above 0.70. Candidates who recommend high yield for diversification are wrong.
- Matching modified duration instead of dollar duration. If assets and liabilities have different market values (which they usually do for underfunded plans), matching modified duration does not match dollar sensitivity. Dollar duration = MV x Duration x 0.01 is the correct hedge metric.
- Forgetting that duration matching only immunizes against parallel shifts. Non-parallel curve movements (steepening, flattening, butterfly) create residual surplus risk. Key rate duration matching is needed for full immunization.
Bottom line
- Fixed income serves four roles (diversification, income, inflation hedging, liability matching); the mandate type (liability-based, total-return, liquidity-based) dictates the instrument.
- Total return management maximizes risk-adjusted return vs. a market benchmark; LDI minimizes surplus volatility vs. liabilities.
- Government bonds diversify equity risk; high yield does not (correlations spike above 0.70 in stress).
- Dollar duration = MV x Modified duration x 0.01; the first-order hedge matches asset dollar duration to liability dollar duration.
Exam shortcut
When a vignette describes a pension or insurer with a liability, compute dollar duration of both assets and liabilities immediately. The gap tells you whether the portfolio is overhedged or underhedged. For curve positioning, remember: barbell = bet on flattening, bullet = bet on steepening. For contingent immunization, compute the cushion first. PV of required terminal value at current rates subtracted from current portfolio value.
The full lesson (about 5,543 words, 37 min read) adds 2 worked examples, all 14 common mistakes, a self-check, free in the app.
Learning objectives
- fi pm overview
Browse all free CFA L3 Portfolio Mgmt lessons or jump into free CFA L3 Portfolio Mgmt practice questions.