Prepayment risk

Table of Contents

Prepayment risk
What is prepayment risk?
Understanding prepayment risk
Purposes of prepayment risk
Working of prepayment risk
Examples of prepayment risk
Frequently Asked Questions

Prepayment risk

Prepayment risk is a complex and frequently misunderstood phenomenon that looms large in the dynamic world of finance, where investors seek consistent returns, and borrowers crave financial flexibility. Prepayment risk, an essential component of fixed-income investments, significantly impacts the financial landscape. Investors and lenders debate the effects of early debt repayment as borrowers take chances to renegotiate their loans or mortgages at cheaper interest rates.

What is prepayment risk?

Prepayment risks relate to the possibility of not receiving all interest payments owed on a mortgage loan or fixed-income security due to the borrower making an early principal repayment.

Mortgage loans, which are often taken for longer terms of 15 to 30 years, are where this risk is most significant. From the borrower’s standpoint, it makes sense to return these loans early to avoid significant interest payments due to the lengthy terms of such loans. Declining interest rates, which encourage borrowers to renew at slower rates and changes in the borrower’s financial situation or the general economic climate, might raise the prepayment risk.

Understanding prepayment risk

Some callable fixed-income instruments carry a prepayment risk because they could be repaid early by the issuer or, in the case of a mortgage-backed asset, the borrower. Due to these provisions, the issuer can redeem the bond before its planned maturity. The issuer of a callable bond can return the investor’s money earlier. The investor then stops receiving interest payments. Non-callable bond issuers need this capability.

Prepayment risk, which refers to the possibility that the issuer will return the principal before paying interest, is, therefore, exclusively connected to callable bonds. Mortgage holders may refinance or pay off their mortgages, which results in the security holder losing future interest in the case of mortgage-backed securities. Such securities’ yield-to-maturity cannot be determined with certainty at the time of purchase since the cash flows related to them are unknown. The bond’s yield will be lower than predicted at the time of purchase if it is bought at a premium.

Purposes of prepayment risk

Prepayment risk is the possibility that borrowers would pay back their loans or mortgages earlier than anticipated, which could adversely impact lenders or investors. In the case of mortgage-backed securities and other fixed-income investments, this risk is prevalent. When interest rates drop, many borrowers repay their existing loans by refinancing to take advantage of the lower rates.

While borrowers may gain from this, investors who anticipated a consistent supply of interest revenue over time face difficulties. The hastened repayment may shorten the investment’s lifespan, which could result in reinvestment at lower rates and lower profits. In contrast, prepayment risk decreases as interest rates rise since borrowers are less inclined to refinance at higher rates. Investors could, however, experience higher default risk.

Working of prepayment risk

There are several circumstances in which someone might prepay their mortgage:

To obtain a lower rate, they decide to refinance their mortgage.
The mortgage must be settled when they sell the house to give the new owner a clear title.
When the insurer settles the homeowner’s insurance claim because the house is damaged, the mortgage is retired.

If investing in MBS, you’ll want to see loans repaid fully but slowly. It’s ideal to have a 30-year mortgage repaid in 30 years because you’ll get all those interest payments along the road in addition to recovering your investment.

Examples of prepayment risk

The following example can help to understand the idea of prepayment risk. A homeowner obtains a mortgage with a 15% interest rate. The market interest rate when taking out a mortgage was 15%. The market interest rate is 10% two years later.

With the drop in market interest rates from 15% to 10%, the lender is in danger of prepayment on the mortgage. So, the homeowner is incentivised to refinance the mortgage from an interest rate of 15% to an interest rate more in line with the current market interest rate of 10%, assuming there are no prepayment penalties or refinancing costs. By doing this, the lender will forego the interest payments that the homeowner would have made throughout the mortgage term.

Frequently Asked Questions

What is the criticism of prepayment risk?

Prepayment risk is problematic since it might work against investors. As callable bonds tend to make interest rate risk unbalanced, they benefit the issuer. Issuers profit from locking in low rates when interest rates rise.

What are the requirements for prepayment risk?

Prepayment risk isn’t present in all bonds. Prepayment risk is absent from a bond if it cannot be called. A bond is a debt investment where a company borrows money from a buyer. During the bond’s maturity, the entity pays the investor periodic interest. The investor’s principal is returned after the time frame. Both callable and non-callable bonds are available.

How is prepayment risk measured or assessed?

Metrics like the weighted average life, or WAL, average life, AL, or prepayment speed are frequently used to assess prepayment risk. These measures aid in estimating the probable impact of prepayments on the duration and cash flows of the underlying loans or MBS.

Can prepayment risk be hedged or mitigated?

While eliminating prepayment risk is difficult, it can be hedged or minimised to some extent in home loans and fixed-income instruments. Derivatives like interest rate swaps or options are one technique to hedge against prepayment risk. These financial products enable lenders and investors to safeguard themselves from unfavourable interest rate changes, which may result in prepayments.

Diversification is also an excellent method to mitigate prepayment risk. The impact of prepayments on the total return can be mitigated by investing in a portfolio of home loans or fixed-income securities with various prepayment characteristics. It is crucial to remember, however, that while these methods can assist in limiting prepayment risk, they can’t eliminate it.

What is extension risk?

Extension risk is a borrowers’ chance to agree to prepayments due to market circumstances. Investments in the secondary market and structured-credit products are typically concerned with extension risk.