By guest contributor Terry Toohey, Consultant, Atchison Consultants
Traditionally investment portfolios are measured against indices in order to gauge the relative success or failure of the portfolio. However, there is a problem with this approach. While comparing one portfolio against a standard portfolio makes a lot of sense in theory, in practice it comes with some problems, especially in the bond market.
The problem can be reduced to one of how the indices are weighted. What type of bonds are included. AAA? High yield? What about the duration of the bonds included in the indices? The solution to these questions is to use constant maturity indices.
Fixed interest portfolios offer the prospect of a relatively high degree of clarity with respect to cash flows. This is why insurance companies, superannuation and pension funds often hold portfolios of bonds
An insurance company providing cover for personal injuries will have a clear perspective of the time frame for payment of benefits which might be five years. An “immunisation” strategy can be introduced which matches durations of expected liabilities and investment assets.
A perfect immunisation strategy establishes a “minimal-impact environment” on an organisation’s cash flows/net asset position. Interest rate movements have virtually no impact on the net asset position of an investor as the impacts on liability and asset values are nearly identical. That is where constant maturity indices come in.
Constant maturity indices maintain stable terms to maturity, durations, coupons and aggregate credit ratings. They are most beneficial as a benchmark for investors with a liability profile which is well-defined. Typical investors of this sort include insurance companies with both long and short term liabilities, variable-rate mortgage providers, defined-benefit superannuation funds and individuals with specific personal requirements in self-managed superannuation funds.