Dedicated portfolio theory, in finance, deals with the characteristics and features of a portfolio built to generate a predictable stream of future cash inflows. This is achieved by purchasing bonds and/or other fixed income securities (such as certificates of deposit) that can and usually are held to maturity to generate this predictable stream from the coupon interest and/or the repayment of the face value of each bond when it matures. The goal is for the stream of cash inflows to exactly match the timing (and dollars) of a predictable stream of cash outflows due to future liabilities. For this reason it is sometimes called cash matching, or liability-driven investing. Determining the least expensive collection of bonds in the right quantities with the right maturities to match the cash flows is an analytical challenge that requires some degree of mathematical sophistication. College level textbooks typically cover the idea of “dedicated portfolios” or “dedicated bond portfolios” in their chapters devoted to the uses of fixed income securities.[1][2][3][4][5][6][7]
The most prolific author on dedicated portfolio theory, Martin L. Leibowitz,[8] was the first to refer to dedicated portfolios as “cash matching” portfolios. He demonstrated how they are the simplest case of the technique known as bond portfolio immunization. In his sketch of its history, he traces the origin of immunization to Frederick R. Macaulay[9] who first suggested the notion of “duration” for fixed income securities in 1938. Duration represents the average life of the coupon payments and redemption of a bond and links changes in interest rates to the volatility of a bond's value. One year later, J.R. Hicks[10] independently developed a similar formulation referred to as the “average period.” In 1942, T.C. Koopmans[11] pointed out in a report that, by matching the duration of the bonds held in a portfolio to the duration of liabilities those bonds would fund, the effects of interest rate changes could be mitigated or nullified completely, i.e. immunized. In 1945, Paul Samuelson[12] formulated essentially the same concept, calling it the “weighted-average time period.” None of these earliest researchers cited each other's work, suggesting each developed the concept independently. The work culminated in a 1952 paper by a British actuary, F. M. Redington.[13]
This body of work was largely ignored until 1971, when Lawrence Fisher and Roman Weil[14] re-introduced immunization to the academic community in a journal article that followed a 1969 report written for the Center for Research in Securities Prices. Shortly thereafter, in 1972, I.T. Vanderhoof[15] presented the concept to the American actuarial community. Academic papers on immunization, duration, and dedication began to appear in increasing numbers, as interest rates began to rise. As rates rose further and further above their long term averages, the financial investment industry began to pay attention, and their inquiries increasingly attracted the attention of academic researchers. Realizing that the high rates would allow them to lock in unprecedented rates of return, defined-benefit pension fund managers embraced the concepts. Goldman Sachs and other high level firms began to produce software to help bond portfolio managers apply the theory to their institutional sized portfolios. Most of the examples used in the literature typically utilized portfolios consisting of several hundred million dollars. In 1981, Leibowitz and Weinberger[16] published a report on “contingent immunization” discussing the blending of active management of bond portfolios with immunization to provide a floor on returns. Leibowitz[17] also published a paper in two parts defining dedicated portfolios in 1986. One of the side benefits of the theoretical work and practical interest was the development of new fixed income instruments, such as zero-coupon bonds.
Example of a dedicated portfolio
While most of the original work on dedicated portfolios was done for large institutional investors such as pension funds, the most recent applications have been in personal investing. This example is a couple who wants to retire this year (call it 20XY, such as 2018) and has already set aside cash to cover their expenses. Social security will supply some income, but the rest will have to come from their portfolio. They have accumulated a retirement portfolio worth $2,000,000 in addition to this year's expenses. Typically, retirement portfolios have a higher percentage of bonds in their portfolio than portfolios owned by younger people who are not yet approaching retirement. Probably the most common retirement portfolio would be a 60/40 stock/bond allocation compared to an 80/20 or 90/10 stock/bond allocation for younger investors. Following a common rule of thumb for retirement withdrawal rates to make a retirement portfolio last at least 30 years, they should withdraw no more than 5 percent from their portfolio next year ($100,000). They can increase it each year by the amount of the previous year's inflation. To be conservative, they will plan for an annual inflation rate of 3 percent (they may not spend it, but want the protection just in case). Table 1,[note 1] lists the projected stream of withdrawals. These withdrawals represent the yearly “income” the couple needs for living expenses over their first eight years of retirement. Note that the total cash flow needed over the entire eight years sums to $889,234.[citation needed]
Table 1
Table 2 shows series of bonds and CDs with staggered maturities whose coupon and principal payments will match the stream of income shown in the Target Cash Flows column in Table 1 (rates are fictitious for this example). The cash flow generated by the portfolio for the first year would be $100,380. This consists of the principal of the bond maturing on February 15 next year plus the coupon interest payments flowing from all the other bonds. The same would be true for the following year and every year thereafter. The total cash flows generated over the eight years sum to $889,350, compared to the target cash flow sum of $889,234, a difference of only $116. As with the first year, the cash flows are very close to the target cash flows needed for each year. The match cannot be perfect because bonds must usually be purchased in denominations of $1,000 (municipal bonds in denominations of $5,000). However, with the use of fairly sophisticated mathematical optimization techniques, correlations of 99 percent or better can usually be obtained. These techniques also determine which bonds to buy so as to minimize the cost of meeting the cash flows, which in this example is $747,325. Note that in this example, the bonds all mature on February 15, the middle of the first quarter. Other dates may be used, of course, such as the anniversary date of the portfolio's implementation.
Table 2
This would be the initial dedicated portfolio for the couple. But they hopefully have a lifetime financial plan designed to last 30 or 40 years. Over time, that means the portfolio will need to be updated or rolled forward as each year passes to maintain the same 8-year time horizon. The time horizon could be extended by adding another bond with an 8-year maturity or the equivalent. Extending on a regular basis could therefore provide a perpetual series of 8-year horizons of protected income over the investor's entire lifetime and become the equivalent of a self-annuity. Whether the replenishment occurs every year automatically or only if other criteria are met would depend on the level of sophistication of the investor or advisor.
The 8 years of bonds can be thought of an “income portfolio” because it is dedicated to providing a predictable steam of income for the next 8 years. The rest of the portfolio can be thought of as a “growth portfolio” because it would be dedicated to providing the growth needed to replenish the income portfolio. The growth portfolio would presumably be invested in equities to achieve sufficient growth.
Recent research has sought to assess investment strategies designed from dedicated portfolio theory. Huxley, Burns, and Fletcher[18] explored the tradeoffs in developing suitable growth portfolio strategies. Pfau[19] compared the performance of dedicated portfolios against other common investment strategies for retirement. In all comparisons, the dedicated portfolio approach provided superior results.
Note that the fixed income securities shown in the example are high quality, safe “investment grade” fixed income securities, CDs and government-sponsored agency bonds, all chosen to avoid the risk of default. United States Treasury bonds could also be used. But they have lower yields, meaning a portfolio of Treasuries to meet the same flows would cost more than CDs and agencies. Triple-A rated corporate bonds are another option and usually have higher yields, but are theoretically riskier than government-sponsored bonds. Also, triple-A rated corporate bonds have become scarce since the financial crisis of 2008 over the wide range of maturities needed for dedicated portfolios. Investors willing to take greater risks may use any quality of bond deemed acceptable in light of their higher yields, though safety would likely be of paramount importance for retirement.
Recall that a secondary goal of dedicated portfolio theory is to select the bonds that will provide the requisite cash flows at the lowest possible cost, given requirements on the minimum quality of bonds to be considered (thus the need for calculation). In this fictitious example, the cost shown is $747,325 to purchase this initial set of bonds, excluding transaction costs and fees, but the actual cost would vary depending on yields, quality of bonds used, and length of the time horizon. It would also depend on the starting time for the cash flows. If this couple planned to retire in five years, they could defer the starting time to coincide with their retirement date. They would buy a dedicated portfolio whose first bond matured in five years, the second in six years, etc. Yields would likely be higher on these bonds because they are further out on the yield curve.
Note that any of the bonds could be zero coupon bonds, meaning they do not pay any coupon interest. It would be easy to build a dedicated portfolio consisting entirely of zero coupon bonds, but their yields can often be lower than coupon bonds. Another problem with “zeros” is that taxes must be paid each year on the increase in value of a zero-coupon bond (assuming it is held in a taxable account), even though no interest was actually received.
Returning to our example, assume that this “income portfolio” were actually purchased, and the balance of the funds were invested in a “growth portfolio” of equity mutual funds or similar types of faster growing investments. The initial asset allocation would become 37% bonds, 63% stocks (see Table 3).
Table 3
Advantages
1. Predictable cash flows. Because the dates and amounts of the coupon and redemption payments are known in advance, individual bonds held to maturity offer something few other financial investments can provide: predictability. Most bond funds cannot provide this certainty because they hold large volumes of many different bonds and typically trade them rather than holding them to maturity. Thus, they behave more like sluggish stock funds in terms of volatility.
2. Avoidance or reduction of investment risks. A number of risks associated with owning bonds are avoided or mitigated by using a dedicated portfolio:
a. Market risk (or capital risk) is avoided because the bonds are held to maturity. The market price at which the bond could be sold at any point in time may rise or fall before it reaches maturity, but these fluctuations are irrelevant to the investor if the bonds are held until they are paid off at face value. Of course, an investor does have the flexibility to sell off the bonds at any time in case an emergency arises.
b. Reinvestment risk is avoided because the interest and principal from the bonds are spent to fund the liabilities (such as the living expenses for the retiree) rather than being reinvested.
c. Inflation risk is mitigated by building an anticipated inflation adjustment into the target cash flows – recall the 3 percent annual adjustment used in the example. If inflation averages more than 3 percent, then the investor’s real income will fall; that is, it will not be sufficient to provide the same standard of living. This inflation risk can be avoided entirely if inflation indexed bonds such as TIPS are used to build the dedicated portfolio. These bonds pay coupon interest plus increase the principal by the rate of inflation from the previous year, then pay coupon interest on the inflated amount the next year. At redemption, they pay the full face value, plus the accumulated inflation.
d. Default risk (or credit risk) is mitigated by using only high quality investment grade bonds similar to those shown in the example above. Investors who are willing to assume more risk can build dedicated portfolios with lower quality bonds, gambling that a sufficient number of them will pay off ultimately.
e. Liquidity risk is mitigated because individual bonds can be sold if the need arises. This is a significant advantage compared to annuities, which are not tradable securities.
3. Specificity. Because dedicated portfolios are designed to provide a specific stream of funds to match future target cash flows, those cash flows must be quite specific in terms of timing and amounts. This need for specificity forces anyone contemplating a dedicated portfolio investment strategy to put careful thought into developing a formal, lifetime financial plan, as opposed to merely relying on vague or hazy goals and hoping for the best. The resulting asset allocation is based explicitly on the plan, instead of a generic model portfolio. This, of course, is the essence of serious financial planning, and the result is a portfolio that is tailored to the specific needs of each investor.
4. Asset Allocation. One of the shortcomings of Modern Portfolio Theory is that it provides only a general notion of how assets should be allocated among the major asset classes (stocks, bonds, and cash). It focuses on the tradeoff between return and volatility – that is, higher returns can be earned only by investments that fluctuate more rapidly and with greater intensity. Dedicated portfolio theory focuses explicitly on cash flows and time horizons. If done properly, it allocates to fixed income no more than the minimum funds necessary to generate the desired cash flows, and all other funds can be invested elsewhere, as demonstrated in the example above. Most investors find this to be a more intuitive explanation for why their assets are allocated the way they are.
5. Passive Management. There are two primary modes of thought on portfolio management. Advocates of active management believe that better returns are achieved by trying to time the market and selecting hot stocks (in other words, trying to predict the future). Advocates of passive management believe that better returns are achieved by buying broad based mutual funds, such as index funds, and holding them. Most academic research suggests that passive management has, in fact, historically produced higher returns over the long run. Dedicated portfolios fall into the category of passive management because once bonds are purchased, they are held to maturity. If all remaining funds are invested in an index fund, then the entire portfolio could be regarded as 100 percent passive. (Index fund providers, such as Dimensional Fund Advisors and Vanguard can supply voluminous research results on the active/passive management debate.)[citation needed]
Disadvantages
Dedicated portfolios are not without disadvantages:
The primary disadvantage of dedicated portfolios is that they are not easy to construct. They require expertise in bonds and other fixed income securities. Not all bonds are suitable for dedicated portfolios. For instance, they cannot use callable bonds because a called bond will create an unpredicted cash inflow that will require reintegration with the stream of undisturbed cash flows.
They require a high level of expertise in the mathematics of optimization theory. To determine the right quantities for each maturity to match the cash flows at minimum cost requires a technique known as mathematical programming.
They require formal financial planning and specificity to develop the target cash flows for each year and determine an appropriate time horizon, which, in turn, require time, thought, and effort on the part of both the investor and the financial advisor.[citation needed]
Footnotes
↑ The 10-year Treasury rose above its long term average in 1968, more than one standard deviation above in 1975, and more than two standard deviations above in 1980, and more than three standard deviations in 1981.
Related Research Articles
In economics and finance, arbitrage is the practice of taking advantage of a difference in prices in two or more markets; striking a combination of matching deals to capitalise on the difference, the profit being the difference between the market prices at which the unit is traded. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit after transaction costs. For example, an arbitrage opportunity is present when there is the possibility to instantaneously buy something for a low price and sell it for a higher price.
In finance, a bond is a type of security under which the issuer (debtor) owes the holder (creditor) a debt, and is obliged – depending on the terms – to repay the principal of the bond at the maturity date as well as interest over a specified amount of time. The interest is usually payable at fixed intervals: semiannual, annual, and less often at other periods. Thus, a bond is a form of loan or IOU. Bonds provide the borrower with external funds to finance long-term investments or, in the case of government bonds, to finance current expenditure.
A zero coupon bond is a bond in which the face value is repaid at the time of maturity. Unlike regular bonds, it does not make periodic interest payments or have so-called coupons, hence the term zero-coupon bond. When the bond reaches maturity, its investor receives its par value. Examples of zero-coupon bonds include US Treasury bills, US savings bonds, long-term zero-coupon bonds, and any type of coupon bond that has been stripped of its coupons. Zero coupon and deep discount bonds are terms that are used interchangeably.
A government bond or sovereign bond is a debt obligation issued by a national government to support government spending. It generally includes a commitment to pay periodic interest, called coupon payments, and to repay the face value on the maturity date. For example, a bondholder invests $20,000 into a 10-year government bond with a 10% annual coupon; the government would pay the bondholder 10% of the $20,000 each year. At the maturity date the government would give back the original $20,000.
In finance, the yield on a security is a measure of the ex-ante return to a holder of the security. It is one component of return on an investment, the other component being the change in the market price of the security. It is a measure applied to fixed income securities, common stocks, preferred stocks, convertible stocks and bonds, annuities and real estate investments.
United States Treasury securities, also called Treasuries or Treasurys, are government debt instruments issued by the United States Department of the Treasury to finance government spending as an alternative to taxation. Since 2012, U.S. government debt has been managed by the Bureau of the Fiscal Service, succeeding the Bureau of the Public Debt.
The yield to maturity (YTM), book yield or redemption yield of a bond or other fixed-interest security, such as gilts, is an estimate of the total rate of return anticipated to be earned by an investor who buys a bond at a given market price, holds it to maturity, and receives all interest payments and the capital redemption on schedule. It is the (theoretical) internal rate of return : the discount rate at which the present value of all future cash flows from the bond is equal to the current price of the bond. The YTM is often given in terms of Annual Percentage Rate (A.P.R.), but more often market convention is followed. In a number of major markets the convention is to quote annualized yields with semi-annual compounding ; thus, for example, an annual effective yield of 10.25% would be quoted as 10.00%, because 1.05 × 1.05 = 1.1025 and 2 × 5 = 10.
Fixed income refers to any type of investment under which the borrower or issuer is obliged to make payments of a fixed amount on a fixed schedule. For example, the borrower may have to pay interest at a fixed rate once a year and repay the principal amount on maturity. Fixed-income securities — more commonly known as bonds — can be contrasted with equity securities – often referred to as stocks and shares – that create no obligation to pay dividends or any other form of income. Bonds carry a level of legal protections for investors that equity securities do not — in the event of a bankruptcy, bond holders would be repaid after liquidation of assets, whereas shareholders with stock often receive nothing.
In finance, the duration of a financial asset that consists of fixed cash flows, such as a bond, is the weighted average of the times until those fixed cash flows are received. When the price of an asset is considered as a function of yield, duration also measures the price sensitivity to yield, the rate of change of price with respect to yield, or the percentage change in price for a parallel shift in yields.
The current yield, interest yield, income yield, flat yield, market yield, mark to market yield or running yield is a financial term used in reference to bonds and other fixed-interest securities such as gilts. It is the ratio of the annual interest (coupon) payment and the bond's price:
Floating rate notes (FRNs) are bonds that have a variable coupon, equal to a money market reference rate, like LIBOR or federal funds rate, plus a quoted spread. The spread is a rate that remains constant. Almost all FRNs have quarterly coupons, i.e. they pay out interest every three months. At the beginning of each coupon period, the coupon is calculated by taking the fixing of the reference rate for that day and adding the spread. A typical coupon would look like 3 months USD LIBOR +0.20%.
A corporate bond is a bond issued by a corporation in order to raise financing for a variety of reasons such as to ongoing operations, M&A, or to expand business. The term is usually applied to longer-term debt instruments, with maturity of at least one year. Corporate debt instruments with maturity shorter than one year are referred to as commercial paper.
In finance, interest rate immunization is a portfolio management strategy designed to take advantage of the offsetting effects of interest rate risk and reinvestment risk.
Fixed-income arbitrage is a group of market-neutral-investment strategies that are designed to take advantage of differences in interest rates between varying fixed-income securities or contracts. Arbitrage in terms of investment strategy, involves buying securities on one market for immediate resale on another market in order to profit from a price discrepancy.
Fixed income analysis is the process of determining the value of a debt security based on an assessment of its risk profile, which can include interest rate risk, risk of the issuer failing to repay the debt, market supply and demand for the security, call provisions and macroeconomic considerations affecting its value in the future. It also addresses the likely price behavior in hedging portfolios. Based on such an analysis, a fixed income analyst tries to reach a conclusion as to whether to buy, sell, hold, hedge or avoid the particular security.
The bond market is a financial market where participants can issue new debt, known as the primary market, or buy and sell debt securities, known as the secondary market.This is usually in the form of bonds, but it may include notes, bills, and so on for public and private expenditures. The bond market has largely been dominated by the United States, which accounts for about 39% of the market. As of 2021, the size of the bond market is estimated to be at $119 trillion worldwide and $46 trillion for the US market, according to Securities Industry and Financial Markets Association (SIFMA).
A bond fund or debt fund is a fund that invests in bonds, or other debt securities. Bond funds can be contrasted with stock funds and money funds. Bond funds typically pay periodic dividends that include interest payments on the fund's underlying securities plus periodic realized capital appreciation. Bond funds typically pay higher dividends than CDs and money market accounts. Most bond funds pay out dividends more frequently than individual bonds.
Reinvestment risk is a form of financial risk. It is primarily associated with fixed income securities, in the form of early redemption risk and coupon reinvestment risk.
Laddering is an investment technique that requires investors to purchase multiple financial products with different maturity dates.
The following outline is provided as an overview of and topical guide to finance:
References
↑ Bodie, Zvi; Kane, Alex; and Marcus, Alan. Investments, 8th ed. McGraw-Hill Irwin, 2009, p. 538.
↑ Bodie, Zvi; Kane, Alex; Marcus, Alan. Essentials of Investments, 8th ed. McGraw-Hill Irwin, 2010, p. 344.
↑ Fabozzi, Frank. Bond Markets, Analysis, and Strategies, 3rd ed. Prentice Hall, 1996, p. 447.
↑ Fabozzi, Frank. The Handbook of Fixed Income Securities. McGraw-Hill, 2005, p. 1103.
↑ Jordan, Bradford and Miller, Thomas. Fundamentals of Investments. McGraw-Hill Irwin, 2009, p. 334.
↑ Sharpe, William; Alexander, Gordon; and Baily, Jeffery. Investments, 5th ed. Prentice Hall, 1995, p. 478.
↑ Fabozzi, Frank. Investing: The Collected Works of Martin L. Leibowitz. Probus, 1992, p. 521.
↑ Macaulay, Frederick R. Some Theoretical Problems Suggested by the Movements of Interest Rates, Bond Yields, and Stock Prices in the United States Since 1856. National Bureau of Economic Research, 1938, p. 44-53.
↑ Hicks, J.R. Value and Capital, Clarendon Press (Oxford), 1939.
↑ Koopmans, T.C. The Risk of Interest Fluctuations in Life Insurance Companies. Penn Mutual Life Insurance Company, 1942.
↑ Samuelson, Paul. The Effect of Interest Rate Changes in the Banking System. American Economic Review, March, 1945, p.16-27
↑ Fisher, Lawrence and Weil, Roman l. “Coping with the Risk of Interest Rate Fluctuations: Returns to Bondholders from Naïve and Optimal Strategies.” Journal of Business 44, No. 4 (October, 1971), P. 408-31.
↑ I.T. Vanderhoof. “The Effects of Interest Rate Assumption and the Maturity Structure of the Assets of a Life Insurance Company.” Transactions of the Society of Actuaries, Volume XXIV, Meetings No. 69A and 69B, May and June, 1972, p. 157-92.
↑ Leibowitz, Martin L., and Weinberger, Alfred. “Contingent Immunization.” Salomon Brothers, Inc. January, 1981.
↑ Leibowitz, Martin L. The Dedicated Bond Portfolio in Pension Funds - Part 1: Motivations and Basics and Part 2: Immunization, Horizon Matching and Contingent Procedures. Financial Analysts Journal, January/February (Part 1) and March/April (Part 2), 1986.
↑ Huxley, Stephen J., Burns, Brent, and Fletcher, Jeremy “Equity Yield Curves, Time Segmentation, and Portfolio Optimization Strategies,” Journal of Financial Planning, November, 2016, P. 54-61
↑ Pfau, Wade “Is Time Segmentation a Superior Strategy?” (4/3/17), www.advisorperspectives.com
Further reading
Huxley, Steven and Burns, J. Asset Dedication: How to Grow Wealthy with the Next Generation of Asset Allocation. McGraw-Hill Education; 1st edition (August 1, 2004). ISBN0071434828.
External links
Asset Dedication - Portfolio engineering firm that builds dedicated portfolios.
Dimensional Fund Advisors website; DFA specializes in index funds and passive management. Its founders did the original research that led to the style box now used to classify funds based on size and value/growth.
Financial Planning Magazine - Article on dedicated portfolios for retirees.
Investopedia - Definition of dedicated portfolios
Vanguard - Vanguard's official website; John Bogle was among the first to start index investing for the general public and Vanguard was the largest mutual fund provider in the world in 2009.
Advisor Perspectives - an online magazine covering articles submitted by financial planners and researchers.
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