SAMPLE 4 – My revisions
There is little credit risk in the Company’s securities portfolio. Except for $35,000 in common stock of a publicly traded company, all of the securities are issued by the U.S. Treasury or by a U.S. government agency. However, the Company’s portfolio poses other types of risk.
First, the Company owns U.S. Treasury Notes and debentures issued by various government agencies. These instruments bear a fixed rate of interest, which presents “interest rate risk.” If the Company holds fixed rate debt while interest rates are rising, the Company will be earning less than a market rate on its investment. To mitigate this risk, the Company has a policy of not acquiring fixed-rate instruments with a maturity of more than five years.
Second, the Company owns a limited number of “Agency callables,” which are securities issued by government agencies that the issuers can choose to redeem before maturity. These instruments pose both “interest rate risk” and “option risk.” Again, interest rate risk is triggered by rising interest rates. If rates increase after the Company purchases a fixed rate callable, the Company will have an investment that earns less than market rates. Declining interest rates trigger option risk. If market rates fall, issuers of callable fixed rate instruments may redeem them before maturity, which will give the Company a return on its investment that is less than we currently expect. The Company mitigates these risks by buying only callables with maturities of five years or less.
Third, the Company owns a $35.0 million portfolio of mortgage-backed securities issued by government agencies. This portfolio comprises $5 million in collateralized mortgage obligations and $30 million in mortgage-backed pass-through securities.
- A “mortgage-backed security” represents ownership of a pool of mortgage loans. As the mortgages are paid off, a portion of the principal and interest payments are “passed through” to the owners of the securities.
- A “collateralized mortgage obligation” is a debt security that is secured by a portfolio of mortgages, mortgage-backed securities, U.S. government securities, or corporate debt obligations.
These securities are subject to risk when interest rates rise or fall. When interest rates are fairly constant, borrowers prepay mortgages (and issuers of mortgage-backed securities prepay their holders) at a predictable rate. Dramatic changes in interest rates will alter the ordinary pace of mortgage prepayments and the related payments to the holders of mortgage-backed securities:
- When interest rates decline, borrowers may choose to prepay their mortgages at a faster pace, which reduces the yield on the related securities. This is “prepayment risk.”
- When interest rates increase, borrowers may refrain from prepaying at the expected rate, which slows the flow of cash to holders of the related securities. This is “extension risk.”
The Company manages prepayment risk by buying mortgage-backed securities with a variety of interest rates, and minimizes extension risk by ensuring that most of its mortgage-backed securities have balloon payments and original maturities no greater than seven years.