Duration Matching for Liability-Driven Investment

ABC Corporation is a mid-sized manufacturing firm that has a pension obligation to pay $500,000 to its retirees annually for the next 10 years. The management is focused on implementing a liability-driven investment strategy, specifically utilizing a duration matching approach to manage their fixed-income portfolio. Currently, the firm holds a portfolio of bonds with a total market value of $5 million and a weighted average duration of 6 years. Given the firm’s cash flow requirements and the interest rate sensitivity of its pension liabilities, management is considering adjusting its bond portfolio to align its duration with its liabilities.

Discuss the concept of duration matching in the context of liability-driven investment strategies. Explain how ABC Corporation can effectively match the duration of its bond portfolio with its pension obligations and the potential risks and challenges associated with this strategy. Additionally, provide an example of how the firm's current bond portfolio could be adjusted to achieve better duration alignment.