Abstract
Protecting against unexpected yield curve, inflation, and longevity shifts are some of the most critical issues institutional and private investors must solve when managing post-retirement income benefits. This paper empirically investigates the performance of alternative immunization strategies for funding targeted multiple liabilities that are fixed in timing but random in size (inflation-linked), i.e., that change stochastically according to consumer price or wage level indexes. The immunization procedure is based on a targeted minimax strategy considering the M-Absolute as the interest rate risk measure. We investigate to what extent the inflation-hedging properties of ILBs in asset liability management strategies targeted to immunize multiple liabilities of random size are superior to that of nominal bonds. We use two alternative datasets comprising daily closing prices for U.S. Treasuries and U.S. inflation-linked bonds from 2000 to 2018. The immunization performance is tested over 3-year and 5-year investment horizons, uses real and not simulated bond data and takes into consideration the impact of transaction costs in the performance of immunization strategies and in the selection of optimal investment strategies. The results show that the multiple liability immunization strategy using inflation-linked bonds outperforms the equivalent strategy using nominal bonds and is robust even in a nearly zero interest rate scenario. These results have important implications in the design and structuring of ALM liability-driven investment strategies, particularly for retirement income providers such as pension schemes or life insurance companies.
Highlights
The superior performance of the M-Absolute strategy using U.S Treasury Inflation-Protected Securities (TIPS) is not accompanied by the Naive portfolio, whose average liability coverage is consistently negative for most maturities, despite the strategy’s positive excess returns
The results suggest that the M-Absolute strategy using U.S TIPS outperforms the equivalent strategy using U.S Treasuries in both the 3-year and 5-year investment horizons
The inclusion of the inflation accrual allied with the divergent behavior of inflation and real interest rates observed in the analyzed sample period, mostly explain the outperformance of the M-Absolute strategy using U.S TIPS
Summary
We use the Nelson and Siegel (1987) parametric approach to estimate the term structure of nominal and real interest rates using U.S government bond data from 2000 to 2018 as an input to compute interest rate risk measures and set up immunizing portfolios. The approach and its extension by Svensson (1995) are widely used by central banks and other market participants for benchmark yield curve estimation, allowing us to directly extract the discount function, to identify the nature of a given shift in the term structure of interest rates and serves the main purpose of testing for immunization strategies, while still promptly capturing distressed events (e.g., the U.S subprime crisis) that significantly impact interest rates and challenge the effectiveness of immunization strategies. T t γ3 γ γ where y(0, τ ) is a function of both the time to maturity τ and a vector of parameters γ0, ..., γ3 to be estimated by solving a non-linear optimization procedure to data observed on a trading day. I =1 and where B(t) the estimated fair value at time t for each coupon bond maturing at τn , with c f cash flow payments (coupons or/and principal redemption) at date τi , with t ≤ τ1 ≤ . . . < τn , and δ(t, τi ) is the discount function derived from the estimated term structure
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