Prepayment Risk

What Is Prepayment Risk?

Prepayment risk is the risk implied with the premature return of principal on a fixed-income security. At the point when debtors return part of the principal early, they don't need to make interest payments on that part of the principal. That means investors in associated fixed-income securities won't receive interest paid on the principal. The prepayment risk is highest for fixed-income securities, for example, callable bonds and mortgage-backed securities (MBS). Bonds with prepayment risk frequently have prepayment penalties.

Understanding Prepayment Risk

Prepayment risk exists in some callable fixed-income securities that might be paid off right on time by the issuer, or on account of a mortgage-backed security, the borrower. These highlights give the issuer the right, however not the obligation, to recover the bond before its scheduled maturity.

With a callable bond, the issuer can return the investor's principal early. From that point onward, the investor receives no more interest payments. Issuers of noncallable bonds lack this ability. Thus, prepayment risk, which depicts the chance of the issuer returning principal early and the investor missing out on subsequent interest, is just associated with callable bonds.

For mortgage-backed securities, mortgage holders might refinance or pay off their mortgages, which brings about the security holder losing future interest. Since the cash flows associated with such securities are uncertain, their yield-to-maturity can't be known for certain at the hour of purchase. In the event that the bond was purchased at a premium (a price greater than 100), the bond's yield is then not exactly the one estimated at the hour of purchase.

Analysis of Prepayment Risk

The core problem with prepayment risk is that it can undermine investors. Callable bonds favor the issuer since they will quite often make interest rate risk one-sided. At the point when interest rates rise, issuers benefit from securing in low rates. Then again, bond buyers are left with a lower interest rate when higher rates are free. There is a opportunity cost when investors buy and hold bonds in a rising rate environment. From a total return point of view, bondholders likewise experience a capital loss when interest rates rise.

At the point when interest rates fall, investors possibly benefit in the event that the bonds are not called. As market interest rates go down, the bondholders gain by continuing to receive the old interest rate, which was higher. Investors can likewise sell the bonds to get a capital gain. Nonetheless, issuers will call their bonds and refinance assuming that interest rates decline substantially, killing the possibility for bondholders to benefit from rate changes. Investors in callable bonds lose when interest rates rise, however they can't win when rates fall.

As a commonsense matter, corporate bonds frequently have call provisions, while government bonds rarely do. That is one motivation behind why investing in government bonds is in many cases a better wagered in a falling interest rate environment. Notwithstanding, corporate bonds actually have higher returns over the long haul.

Investors ought to consider prepayment risk, as well as default risk, before picking corporate bonds over government bonds.

Requirements for Prepayment Risk

Not all bonds have prepayment risk. In the event that a bond can't be called, then it doesn't have prepayment risk. A bond is a debt investment where an entity gets money from an investor. The entity makes ordinary interest payments to the investor throughout the bond's maturity period. Toward the finish of the period, it returns the investor's principal. Bonds can either be callable or noncallable.

Instances of Prepayment Risk

For a callable bond, the higher a bond's interest rate relative to current interest rates, the higher the prepayment risk. With mortgage-backed securities, the probability that the underlying mortgages will be refinanced increments as current market interest rates fall further below the old rates.

For instance, a homeowner who takes out a mortgage at 7% has a lot more grounded incentive to refinance after rates drop to 4% or 5%. When and assuming the homeowner refinances, the people who invested in the original mortgage on the secondary market don't receive the full term of interest payments. Assuming they wish to keep investing in the mortgage market, they should acknowledge lower interest rates or higher default risk.

Investors who purchase a callable bond with a high interest rate take on prepayment risk. As well as being highly corresponded with falling interest rates, mortgage prepayments are highly related with rising home values. That is on the grounds that rising home values give an incentive to borrowers to trade up their homes or use cash-out refinances, the two of which lead to mortgage prepayments.

Highlights

• Prepayment risk can undermine investors by making interest rate risk one-sided.
• Prepayment risk is the risk implied with the premature return of principal on a fixed-income security.
• Prepayment risk for the most part influences corporate bonds and mortgage-backed securities (MBS).
• At the point when prepayment happens, investors must reinvest at current market interest rates, which are normally substantially lower.