Have you ever wondered how your business can allocate resources for future expenses in a financially savvy way?
Let’s talk about asset liability hedging with bonds! It’s a very well practiced strategy for large institutions and pension funds albeit they also integrate stock portfolios into the mix. Typically the industry will use a combination of risk-on and risk-off allocations. If you attempt to have one set of allocations behave in a multitude of manners you’re likely to underperform all the strategy specific goals.
Firstly, let’s say your business or fund has 7 million dollars in total due in the next 4.5 years. However, the payment amounts and due dates vary. How do you calculate this into an aggregate sum to do math conveniently?
Calculating Present Value of Liabilities
A sum of money now is often less than in the future. We can apply this principle to liabilities.
The concept is that if we invest our money in a bond that pays 3% interest annually our initial sum required to pay off the total debt is less than the sum.
Mathematically this looks like…
… where B(t) relates to the rate of return of the bond and PV(L) relates to the present value of the liabilities.
If the math is intimidating feel free to Google “Present Value Calculator” and apply the concepts in an assisted fashion.
Liabilities
1.0M – 3.0Y
1.5M – 3.5Y
2.0M – 4.0Y
2.5M – 4.5Y
While these liabilities total $7,000,000 since they are due in the future with different payouts one would only need…
$6,233,320.32 to afford the payments. This is due to the time value of money given by the market.
This concept may appear obvious to many but it is surprising how few account for the actual present value of liabilities and instead use the full amount.
Calculating Funding Ratio
Funding Ratio’s are commonly used in pension funds and financial situations when future disbursements or payments are known.
The math on this is a simple ratio of …
assets / present value of liabilities
As an example to illustrate how important the interest rate is on the bond, let’s say we only have $5,000,000 and have 3% and 2% rate scenarios.
5M at 3% puts our funding ratio at 80.21%
5M at 2% puts our funding ratio at 77.20%
