You may come across the concept of matching as your net worth grows and you start to amass riches when managing your portfolio.
A matching strategy (or cash flow matching) is the identification and accumulation of investments with dividends that correspond with a person's or a business's liabilities. It is a particular kind of devotion strategy in which expected returns on a portfolio of investments are matched to pay for those projected future liabilities.
A matching strategy chooses each investment depending on the investor's risk tolerance and cash flow needs. The payout may include dividends, coupon payments, or principal repayment.
Understanding matching strategy
A matching strategy pairs the durations of assets and liabilities in a fixed-income portfolio. The objective is to create a portfolio in which the two elements of total return—price return and reinvestment return—exactly counterbalance each other when interest rates change. In practice, exact matching is challenging.
A cash flow matching strategy uses future principal and coupon payments from various bonds or other assets selected so that the overall cash flows will perfectly fit the liabilities amounts to achieve this.
Price risk and reinvestment risk are inversely correlated, and even if interest rates change, the portfolio will still generate the same fixed rate of return. In other words, it is "immunized" against changes in interest rates. Another technique is cash flow matching, which uses cash flows from principal and coupon payments on fixed-income securities to pay for a stream of liabilities at predetermined time intervals.
How does a matching strategy work?
To implement the cash flow matching strategy, you first need to rearrange your portfolio so that you can turn assets into cash when needed. You might choose to convert a portion of your equities into cash-equivalent investments that mature when you need the money, such as short-term government bonds or zero-coupon bonds.
You can be charged capital gains tax or other fees depending on the investment you choose when you convert your assets. Before you convert any purchases, be careful to know how much you'll be hit with to calculate how much overall money you'll need to reach your desired amount.
Cash flow matching example
Total cash flow
A liability stream projected over four years is shown in the table above. We begin by financing the final liability with a four-year $10,000 face value bond with annual coupon payments of $1,000 to meet these future liabilities with cash flow matching (Row C4 in the table).
At the end of year four, the principal and coupon payments cover the $11,000 liability.
Next, we examine liability 3, an $8,000 liability funded through a bond with a three-year face value of $6,700 and yearly coupon payments of $300. The second liability is for $9,000 and is funded with a bond having a two-year maturity and a face value of $7,000 with an annual coupon payment of $700. Finally, we can finance liability by purchasing a one-year, $3,000 value zero-coupon bond.
Connecting a cash flow to a liability stream in the real world can be difficult.
First, any bonds may not be available with the necessary face values and coupon payments. Second, the excess funds can be available before liability is due, and these extra funds need reinvestment at a moderate short-term rate. In a cash flow matching method, this increases the risk of reinvestment.
Again, you can use linear programming techniques to choose a group of bonds in a specific situation and produce a cash flow match with the least reinvestment risk.
What is a Maturity Matching Strategy?
A working capital financing method called maturity matching or hedging involves financing short-term needs with short-term debts and long-term needs with long-term obligations. According to the underlying principle, a financial instrument having almost the same maturity should finance each asset.
When to use the Matching strategy?
Here are a few cases where you can think about creating and putting into practice a matching strategy.
- Making retirement plans
Retirement investors who rely on steady payments to complement Social Security benefits are often retirees living off their assets' income. A matching strategy would entail the deliberate acquisition of securities that periodically pay dividends and interest. A matching strategy should be in place long before retirement years start, and a pension fund would use similar tactics to meet its benefit obligations.
- Giving money to your kids, grandchildren, nieces, nephews, or any heirs or beneficiaries to attend college.
- To buy a primary residence, a second residence, or investment property.
- For a mortgage's or another debt's maturity with a balloon payment provision in the promissory note
- As part of a multi-year or multi-decade estate tax reduction strategy intended to reduce the value of your estate, you make recurring tax-free gifts up to the gift tax limits.
- Financing prospective settlements for legal actions or other liabilities could take years to resolve.
- Putting money aside to cover a child's wedding costs
- Putting aside money to pay off a limited partnership partner, a limited liability company member, or a corporate stockholder
- Putting money aside to pay an anticipated tax bill
- A matching strategy for a manufacturing company, infrastructure developer, or construction company would involve matching the project or investment's debt finance repayment schedule with the investment's cash flows. For instance, a company building a toll road would get project funding, start repaying the debt as soon as it was open to traffic and keep making the agreed-upon payments over time.
A matching strategy uses an asset to cover future liabilities by investors. Investors swap out one or more of their portfolio's assets for more liquid ones. A matching strategy can hedge reinvestment, liquidity, and action bias risk. You can use Liability-driven investment for a variety of expenses.