Liability Matching

Liability Matching is that the practice of attempting to project the precise timing of money needs, particularly outflows, by an investor then making capital allocation decisions during a way that places stress on increasing the possibilities that the assets within the portfolio are going to be sold or liquidated, producing sufficient passive income.

It is an expensive investment strategy that suits future asset sales and even income streams against typically the timing of expected potential expenses. The particular strategy has become broadly embraced among pension finance managers, who attempt in order to minimize a portfolio’s liquidation risk purchasing a new asset revenue, interest, and dividend repayments correspond with expected obligations to pension recipients. This stands in contrast to simpler strategies that attempt to maximize return without regard to withdrawal timing.

In another way, one might experience a liquidity event that may ensure the greenbacks are there when the investor goes to achieve for them within the time of his or her need. Part and parcel of an intelligently-designed asset/liability matching program is attempting to get satisfactory risk-adjusted results within the confines of the restrictions arising from the expected income timing needs.

Buy-and-hold and indexing strategies are about generating steady rates of return during a portfolio. But a structured portfolio strategy (also called a dedicated-portfolio strategy) is for investors who must ensure their portfolios are worth a selected amount at a particular point within the future, actually because they have to fund future liabilities like tuition or retirement. Liability matching is one in every of two types of structured portfolio strategies (the other is immunization), and it’s intended for investors who must fund a series of future liabilities.

Liability matching is growing in popularity among sophisticated financial advisers and wealthy individual clients, who are using multiple growth and withdrawal scenarios to make sure that adequate cash are going to be available when needed. The employment of the town method of study, which uses a malicious program to average the results of thousands of possible scenarios, has grown in its popularity as a time-saving tool wont to simplify a liability matching strategy.

To apply the liability matching strategy, the investor first purchases an instrument with a face value or eventual maturity that’s adequate to the number of the last liability in his time horizon. The investor then reduces the remaining liabilities within the liability stream by this bond’s coupon payments and purchases another bond to fund the next-to-last liability adequate to the quantity of the liability less any coupon payment from the primary bond. The investor goes backward in time using this approach until all the liabilities are matched by interest and principal payments from the portfolio.

For example, retirees living off the income from their portfolios generally depend on stable and continuous payments to supplement social insurance payments. An identical strategy would involve the strategic purchase of securities to pay dividends and interest at regular intervals. Ideally, an identical strategy would be in situ well before retirement years commence. A pension fund would use the same strategy to form sure its benefit obligations are met.

The biggest advantage of using an asset/liability matching approach in portfolio management is that it can allow us to significantly reduce many of the risks we might face as an investor if the program is designed and implemented wisely.

Actually, Liability matching requires the investor to calculate and time his or her future liabilities, which isn’t always easy or accurate. However, liability matching doesn’t require the investor to line the duration of the portfolio up to the investor’s time horizon (this is named duration matching), nor must he constantly buy and sell to rebalance the portfolio unless a selected bond’s credit risk becomes unacceptable. Thus the liability matching approach generally contains a lower sensitivity to changes in interest rates than the immunization approach. These are great advantages, but it’s important to notice that liability matching will be costlier than immunizing because it often requires overfunding so as to make sure that the longer-term liabilities are covered.

 

Information Sources:

  1. investinganswers.com
  2. thebalance.com
  3. investopedia.com