WHAT IS IMMUNIZATION?

Immunization is used with bonds and bond portfolios to lock in a fixed rate of return during a given time horizon—the amount of time you wish to keep your money invested without withdrawing it.

Normally, interest rates affect bond prices inversely. When interest rates go up, bond prices go down. But when a bond portfolio is immunized, the investor receives a specific rate of return over a given time period, regardless of what happens to interest rates during that time. In other words, the bond is "immune" to fluctuating interest rates.

To achieve immunization, an investor must know the bond's duration. Duration measures a bond's market risk and price volatility in response to a given change in interest rates. Duration is a weighted average of the bond's cash flows over its life. The weights are the present value of each interest payment as a percentage of the bond's full price. The longer the duration of a bond, the greater its price volatility.

Duration is used to determine how a bond will react to changing interest rates. For example, if interest rates rise 1 percent, a bond with a two-year duration will fall about 2 percent in value.