Two portfolio managers are discussing the investment characteristics of amortizing securities

Manager A believes that the advantage of these securities relative to nonamortizing securities is that because the periodic cash flows include principal repayments as well as coupon payments, the manager can generate greater reinvestment income. In addition, the payments are typically monthly so even greater reinvestment income can be generated. Manager B believes that the need to re-invest monthly and the need to invest larger amounts than just coupon interest payments make amortizing securities less attractive. Whom do you agree with and why?

Manager A's belief about the superiority of amortizing securities reflects a simultaneous belief that reinvested cash flows that are received earlier can be in turn invested at a higher rate. With amortized securities, greater cash flows come early because both periodic principal repayments and periodic coupon interest payments are received. If you felt Manager A's belief was justified, you would tend to agree in the superiority of choosing amortizing securities. However, there are problems with this belief.

First,the cash flows are monthly, not semiannually as with nonamortizing securities, which means that manager A would have to not only reinvest both periodic coupon interest payments and principal, but must do it more often. This not only increases reinvestment riskif his belief is wrong but more time and costs must be spent in constantly reinvesting funds. Second, even if manager A's beliefis justified, another problem develops if the borrower prepays early thereby accelerating the periodic principal repayment. For this scenario, manager A would never realize the opportunity to reinvest greater funds at a greater rate. Third, let us assume rates fall. For this situation, manager A is stuck with investing greater cash flows for longer periods of time at lower rates. When all is said and done, it would appear that manager A's belief can lead to costly results.

However, there is another consideration that will lessen the favorability of manager B's preference. For example, in regard to accelerating the periodic principal repayment, nonamortizing securities typically allow for a greater acceleration of the periodic principal repayment for the borrower who will tend to prepay when interest rates decline. Consequently, if a borrower prepays when interest rates decline, thenmanager B faces greater reinvestment risk because the prepaid principal will be invested at a lower interest rate. If this is case, then manager A's choice of amortizing securities may do a better job of avoiding reinvestment risk.