Prepayment RiskExplained & Defined
What Is Prepayment Risk?
The risk involved in the event of paying the principal amount earlier than the agreed term is called a Prepayment Risk.
The bondholder might be losing the chance to earn additional interest income when part or all of the principal is returned early because interest is computed based on the principal amount.
Security types prone to this type of risk are fixed-income securities.
Examples of these are callable bonds and mortgage-backed securities.
The countermeasure of bondholders for this type of risk is the imposition of fines and penalties whenever the debtor wishes to settle the principal amount earlier than the agreed term.
Understanding Prepayment Risk
The two common securities subject to prepayment risk are callable bonds and mortgage-backed securities.
The bond issuer of the callable bonds may settle the obligation to the holder earlier than the agreed maturity date.
The settlement of the principal amount terminates the contract. This means the bondholder is no longer entitled to any future interest income.
However, non-callable bonds are excluded from this method of early debt settlement. The early redemption of bonds only applies to callable bonds.
The mortgage-backed security is a type of debt agreement that allows the borrower to settle his debt earlier than the agreed terms.
Same with callable bondholders, the investor of this security will no longer be receiving interest payments after the early settlement of the principal amount.
At the time of purchase, the yield to maturity is uncertain due to unstable cash flows associated with mortgage-backed securities.
Whenever the bond issuance is at a premium, the estimated bond yield is lower at the time of purchase.
This type of security tends to lose future interest income due to holders deciding to refinance the debt or early settlement.
Criticism of Prepayment Risk
The prepayment risk mainly affects the bondholders because the realization of the future interest income no longer exists due to the early settlement of the bond obligation of the bond issuer.
Also, the bond issuer benefits from a locked-in interest rate agreement.
The parties must stick to the agreed interest rate whenever the market interest rate rises.
The downside to this would put the bondholder in an unfair position because they will not be able to take advantage of rising interest rates.
Advantages for bondholders exist when:
- With lower market interest rates, the holder may still gain because the parties will still stick to the agreed interest rate but this will only be possible if the bonds have not yet been called.
- The holders may sell the bonds to other interested investors which can result in a capital gain.
When the interest rates continue to fall, the bond issuer’s remedy is to exercise the call their bonds or enter into refinancing, but bondholders will not benefit even if the interest falls, much more if the interest rate rises.
In the real world, it is more secure to invest in government bonds because these types of securities are non-callable bonds, while corporate bonds can either be callable or non-callable.
Requirements for Prepayment Risk
Only callable bonds are subject to prepayment risk.
The owner of the bond is the bond issuer who is also the borrower in this type of agreement, while the bondholder is the investor who lends money to the bond issuer.
It is a debt investment in which the bond issuer has to pay a monthly amortization for the loaned amount until its maturity.
This type of bond is categorized as either callable or non-callable.
Examples of Prepayment Risk
A callable bond has a high prepayment risk whenever its agreed bond interest rate is relatively higher than the current market interest rate.
Mortgage-backed agreements will likely be refinanced whenever the old interest rates are higher than current market interest rates.
For example, a real estate owner who applied for a mortgage loan with an 8% interest rate will likely refinance their mortgage due to a massive plummeting of the current interest rate to 3%.
Refinancing will prohibit the investors of the said mortgage on the secondary market from receiving the interest payments based on the original agreement.
Should they want to continue to invest, they must be prepared for higher default risk and a lower interest rate relative to the mortgage.
Bondholders of a callable bond must expect a prepayment risk for bonds with a relatively high-interest rate.
Rising home market value and falling interest rates lead to mortgage prepayments.
When home values increase, homeowners can decide to refinance their mortgage or trade up their current homes.
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NYU Stern "Prepayment Risk and Expected MBS Returns∗" White paper. September 23, 2022
Fort Hays State University "A NOTE ON THE EFFECTS OF PREPAYMENT RISK ON MORTGAGE COMPANIES AND MORTGAGE REITs" White paper. September 23, 2022