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Balancing Portfolio Risk With Commercial Mortgage Backed Securities

A common weakness in bank investment portfolios is inadequate call protection. In a quest to maximize current yield, bank portfolios tend to be concentrated in bonds with embedded call options. While callable instruments can be an effective yield enhancement technique when used in moderation, an overabundance of these securities can expose portfolios to significant reinvestment risk in a declining interest rate environment. Many institutions experienced the adverse consequences of relying too heavily on callable bonds during the falling rate cycle of 2001 to 2003. During this period, portfolio managers were forced to reinvest the proceeds of called bonds at progressively lower rates, which ...

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