Dedicated Portfolio Theory

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.

The most prolific author on dedicated portfolio theory, Martin L. Leibowitz, 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 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 independently developed a similar formulation referred to as the “average period.” In 1942, T.C. Koopmans 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 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.

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