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Average Life

Average Life
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What Is Average Life?

The average life is the timeframe the principal of a debt issue is expected to be outstanding. Average life doesn't consider interest payments, however just principal payments made on the loan or security. In loans, mortgages, and bonds, the average life is the average period of time before the debt is repaid through amortization or sinking fund payments.

Investors and analysts utilize the average life calculation to measure the risk associated with amortizing bonds, loans, and mortgage-backed securities. The calculation provides investors with a thought of how rapidly they can anticipate returns and gives a valuable measurement to looking at investment options. As a general rule, most investors will decide to receive their financial returns prior and will, hence, pick the investment with the more limited average life.

Figuring out Average Life

Likewise called the weighted average maturity and weighted average life, the average life is calculated to determine what amount of time it will require to pay the outstanding principal of a debt issue, like a Treasury Bill (T-Bill) or bond. While certain bonds repay the principal in a lump sum at maturity, others repay the principal in portions over the term of the bond. In cases where the bond's principal is amortized, the average life permits investors to determine how rapidly the principal will be repaid.

The payments received depend on the repayment schedule of the loans backing the particular security, for example, with mortgage-backed securities (MBS) and asset-backed securities (ABS). As borrowers make payments on the associated debt obligations, investors are issued payments mirroring a portion of these cumulative interest and principal payments.

Working out the Average Life on a Bond

To work out the average life, duplicate the date of every payment (communicated as a small portion of years or months) by the percentage of total principal that has been paid by that date, add the outcomes, and separation by the total issue size.

For instance, assume a yearly paying four-year bond has a face value of $200 and principal payments of $80 during the main year, $60 for the subsequent year, $40 during the third year, and $20 for the fourth (and last) year. The average life for this bond would be calculated with the accompanying formula:

($80 x 1) + ($60 x 2) + ($40 x 3) + ($20 x 4) = 400

Then partition the weighted total by the bond face value to get the average life. In this model, the average life equals 2 years (400 isolated by 200 = 2).

This bond would have an average life of two years against its maturity of four years.

Mortgage-Backed and Asset-Backed Securities

On account of a MBS or ABS, the average life addresses the average time span required for the associated borrowers to repay the loan debt. An investment in a MBS or ABS includes purchasing a small portion of the associated debt that is packaged inside the security.

The risk associated with a MBS or ABS centers on whether the borrower associated with the loan will default. On the off chance that the borrower neglects to make a payment, the investors associated with the security will experience losses. In the financial crisis of 2008, a large number of defaults on home loans, particularly in the subprime market, prompted huge losses in the MBS arena.

Special Considerations

While unquestionably not so critical as default risk, another risk bond investors face is prepayment risk. This happens when the bond issuer (or the borrower on account of mortgage-backed securities) pays back the principal sooner than scheduled. These prepayments will reduce the average life of the investment. Since the principal is paid back ahead of schedule, the investor won't receive future interest payments on that part of the principal.

This interest reduction can address an unexpected test for investors of fixed-income securities dependent on a solid stream of income. Therefore, a few bonds with payment risk incorporate prepayment penalties.

Features

  • The average life is the average timeframe it will take to repay the outstanding principal on a debt issue, for example, a Treasury bill, bond, loan, or mortgage-backed security.
  • Most investors will pick an investment with a more limited average life as this means they will receive their investment returns sooner.
  • The average life calculation is helpful for investors who need to compare the risk associated with different investments before pursuing an investment choice.
  • Prepayment risk happens when the loan borrower or bond issuer repays the principal sooner than scheduled, in this way shortening the investment's average life and decreasing the amount of interest the investor will receive.