Bond duration matching

Bond duration matching is a portfolio strategy that aligns the duration of a bond portfolio with the timing of a known future liability or a specific investment horizon. Since duration measures how sensitive a bond's price is to changes in interest rates, matching it to when the money will be needed protects the investor from having to sell bonds at an unfavorable price if rates move before that date arrives.

The logic works because a bond's price risk and reinvestment risk move in opposite directions as rates change. If rates rise, a bond's price falls, but the coupons it pays can be reinvested at the new, higher rate. If rates fall, the bond's price rises, but future coupons are reinvested at a lower rate. When duration is matched to the investment horizon, these two effects roughly offset each other, so the value of the portfolio at that target date is largely protected from interest rate swings in either direction. This technique is sometimes called immunization for that reason.

Pension funds and insurance companies use duration matching heavily, since they know with some precision when they will need to pay out benefits or claims and want the bond portfolio funding those payouts to be worth a predictable amount when the bill comes due. An individual investor can apply the same idea more loosely, choosing bonds or a bond fund with a duration close to a known need, such as a child's college costs in a specific year, rather than holding bonds with a much longer or shorter duration than that target.