Duration Matching

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21 Aug, 2024

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Duration Matching refers to a strategy used by financial institutions to measure and manage interest rate risk due to any changes in fixed-income instruments like bonds. It aims at closely matching the asset duration with the loan duration to manage the vulnerability to minute fluctuations in interest rates.

It does not remove the interest rate risk. The duration gap determines the degree of matching the timings of cash outflows and inflows. The process of asset liability management primarily considers asset-liability discrepancies. There are multiple ways to measure duration, including the most common Macaulay’s duration.

What Is Duration Matching?

Duration matching is a technique used by financial institutions to assess and contain interest rate risk in response to modifications in fixed-income securities like bonds.
It strives to precisely align the loan’s duration with that of the asset's lifetime by minimizing exposure to minor interest rate changes.
The primary objective is to match investors’ horizons with bond portfolio duration, whereas cash flow matching aims at aligning portfolio cash flows with plan liabilities.
Its benefits are increased portfolio stability, predictable cash flows, minimized interest rate risks, risk-adjusted yields, and aiding investors in immunizing portfolios to make liability payments from assets' cash inflows.

Duration Matching Explained

Duration matching is defined as a trading strategy by a firm or individual to match the asset’s cash inflows with those of their liabilities’ cash outflows to minimize any unfavorable interest rates associated with their investments. Individuals can execute it to minimize interest rate impacts on their portfolio investments. Businesses, too, can utilize this strategy to safeguard their total assets from any volatile interest rate trends. Investors and asset managers can choose assets and investments based on cash flow requirements and risk profiles.

One can easily forecast asset or investment returns that match with liability payments aligned at equal intervals. It works by searching for appropriate fixed-income security or instruments that provide the required amount of cash flow matching the cash outflows of the liability, like a loan. However, the matching involves precise liabilities and assets having the exact durations. It helps protect individuals and organizations against adverse movements in interest rates.

Bonds with fixed incomes move inversely to interest rate movements. Investors consider coupon payments and principal repayments to match the total cash inflows as opposed to liability payment requirements. Besides, one also has to look at a bond’s key rate duration matching, maturity period, the value of a bond amount to fulfill cash flow needs in the future, and interest rate. However, in reality, it becomes difficult to find bonds that have matching cash flows with loan repayment.

Institutional investors use it to mitigate risk and get stable cash flows. It also aligns asset duration with that of liabilities, thereby decreasing exposure to volatility. It plays a significant role in the financial world with institutional portfolios.

Examples

Let us use a few examples to understand the topic.

Example #1

Let us assume a company has to repay its loan in five installments, as shown below:

Time	1^st Year	2^nd Year	3^rd Year	4^th Year	5^th Year
Loan Payment	6,000	7,000	9,000	12,000	16,000
Principal Payment	3,400	4,400	7,200	10,500	15,000
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

Hence, the company needs to find five separate coupon bonds to fund these liabilities. First, one has to find a bond with a face value (FV) of $15,000 and a coupon payment (CP) of $1,000 with a maturity of 5 years to satisfy the final loan payment. After that, choose a bond with an FV of $10,500, a 4-year maturity period, and a CP of $500.

Likewise, continue in the same manner till we find a zero-coupon bond, a 1-year maturity period, and an FV of $3,400. Therefore, by simply matching the duration of principal payments and bond coupons, the company could match its loan repayment over the next five years.

Example #2

An article published on August 23, 2023, talks about non-bank lenders using duration matching to attract more borrowers. Private non-bank credit providers like Ares Management, KKR, and Global Management have gained from banks’ tighter lending policies. Such private lenders provide predictability and stability to borrowers through funding loans from dedicated capital derived from investment products like annuities and life insurance policies.

As a result, they can utilize superior duration matching of asset-liability to reduce risk related to multi-year credit against non-liquid assets. Therefore, it has led to unprecedented growth in private lending, with assets under their control reaching $1.3 trillion, which is expected to grow to a staggering $2 trillion in the next five years. As banks are facing tighter regulations, Apollo Global, the private lender, is poised to leverage the growth of the private lending market.

Benefits

It has multiple benefits for institutions and individuals alike, as listed below:

It increases portfolio stability by increasing risk-adjusted yields, ensuring predictable and stable cash flows, and minimizing interest rate risk.
Fixed-income investors can eliminate interest rate risk by matching them with their investment horizon.
It acts as the best tool to immunize portfolios from interest rate risk.
Individuals and institutions can match their liability payments through bond investments.
This strategy also helps firms and individuals protect their assets from adverse market trends in interest rates.

Duration Matching vs Cash Flow Matching

The asset-liability portfolio management (ALM) uses both ALM duration matching & cash flow matching to protect the financing of certain future liabilities, but they have differences, as listed in the table below:

Duration Matching	Cash Flow Matching
The objective is to match investors’ horizons with bond portfolio duration.	It aims to align portfolio cash flows with plan liabilities.
It remains more flexible than cash flow matching.	This method is simple to use, but it is subject to specific securities provisions.
Using it in conjunction with cash flow matching has its advantages.	It has less flexibility since it needs specific types of securities.
It cannot obliterate the volatility of funded status.	Showcases precision cash flow monitoring, so it is relatively stable.
Only specific kinds of investors can use it.	Commonly available by relying on the availability of specific securities.
It uses linear programming methodology as a risk management technique for creating an immunization portfolio.	Risk management concentrates on matching cash flow amounts and timing.

Frequently Asked Questions (FAQs)

What is bond duration matching?

It is done by choosing bonds with a duration equal to that of the investment horizon set by the investor. As a result, investors could reduce the risk related to losses owing to fluctuations in interest rates and then accordingly plan for cash flows in the future.

What is the duration matching strategy for immunization?

The strategy involving immunization means balancing the contrasting effects that interest rates have on the investment return and price return due to a coupon bond. Moreover, numerous liability strategies tend to pay off in a better manner if the interest rate transforms and is reasonable.

What is duration matching in Occam investing?

It has been explained as having a long bond duration but with a short-term investment horizon, which leads to more price risk and less reinvestment risk. As a result, it becomes easy to neutralize the risks when matching bond duration with investment horizon, like both being long or both being short, as one does not take any interest rate risk.