Type I, II, III, IV liabilities
There are different types of liabilities that fixed income managers should be familiar with. In particular, we have Type I, Type II, Type III and Type IV liabilities. On this page, we discuss the different types of liabilities that a fixed income fund manager should be able to distinguish.
Type I liabilities
The first type of liabilities are known future amounts and payout dates. A simple example of a Type I liability is an option-free fixed-rate bond. These kinds of liabilities are easiest to model.
Type II liabilities
The second type of liabilities are known future amounts but uncertain payout dates, called Type II liabilities. An issuer of a callable bond or a putable bond has this type of liability. Another example is an insurance company selling term life insurance. While the amount of the payout is known, the date of payout on any single policy is not known in advance. Still, using statistics, it is possible to estimate the likely payout amounts in case of a portfolio with many such insurance plans.
Type III liabilities
The third type of liabilities have uncertain future amounts but known payout dates. These are called Type III liabilities. An example of Type III liabilities are floating rate instruments and real rate bonds such as Treasury Inflation Protection Securities (TIPS).
Type IV liabilities
The final type of liabilities have both uncertain future amounts and uncertain payout dates. These are referred to as Type IV liabilities. Good examples are property and casualty insurance as well as some defined benefit plan liabilities.
We discussed types of liabilities. Depending on the type of liability, it can be easy to model them (e.g. Type I liabilities) or really hard to model them (Type IV liabilities). Simple duration is enough to model Type I, while others require effective duration.