Prepayment Risk: Investment Products To Avoid

Prepayment risk refers to the risk that a borrower repays their loan earlier than expected. This poses a challenge to lenders as it results in excess fund deployment issues and the loss of prefixed interest payments. This risk is particularly relevant in mortgage borrowing, where borrowers can refinance or repay their debt before its scheduled maturity. Mortgage-backed securities (MBS) are a common investment product that faces prepayment risk. MBS are groups of home mortgages that are packaged and sold as a single security. When homeowners repay their loans earlier than expected, investors in MBS face the risk of lower future interest payments. To mitigate this risk, prepayment penalties are often imposed on homeowners who repay their loans early.

Mortgages and home loans

MBS are created when banks or agencies bundle together a group of home mortgages and sell them as a single security, known as "securitization." Investors who purchase MBS expect to receive returns based on the principal and interest payments from borrowers over the life of the loans. However, if borrowers repay their mortgages earlier than expected, investors in MBS face the risk of losing out on future interest payments. This scenario is known as prepayment risk.

For example, consider a buyer who takes out a $200,000 home loan with a 30-year fixed rate of 5%. The entity that buys this mortgage expects to receive interest payments over the full 30-year term. However, if the borrower repays the loan early, the purchaser will not receive all the anticipated future payments, resulting in a lower overall return on their investment.

To mitigate prepayment risk, lenders often impose prepayment penalties on homeowners who repay their home loans earlier than expected. Additionally, rising interest rates can reduce the risk of prepayment as borrowers may be less likely to refinance or repay their loans early to avoid higher future interest payments.

While prepayment risk is a potential concern for investors in MBS, it is not typically a significant issue for individual homeowners looking to pay off their mortgages early. In most cases, there are no penalties for early repayment, and homeowners can benefit from saving on interest costs.

Mortgage-backed securities (MBS)

MBS are collateralised by a pool of residential mortgages. Monthly interest payments "pass through" the originating bank to a third-party investor. In addition to these monthly interest payments, mortgages amortise over their lifetime, meaning that some amount of principal is paid off with each monthly payment. This is in contrast to a bond, which generally pays all principal at maturity.

The prepayment risk associated with MBS comes from the fact that investors receive unscheduled prepayments of principal on a pro-rata basis due to refinancing, foreclosure, and house sales. As a result, it is difficult to predict the maturity of an MBS.

Prepayment risk is highest when interest rates are falling, as this incentivises homeowners to refinance their mortgages. When interest rates fall, investors are compensated with an additional yield or spread above the yield on a comparable US Treasury bond.

To mitigate prepayment risk, investors can use the weighted average life (WAL) of an MBS, which is a statistic that measures the effective maturity of the security. By calculating the WAL, investors can make more realistic predictions about the yield and term of an MBS, thereby reducing the inherent prepayment risk.

Reinvestment risk

In the case of an inverted yield curve, investors may be tempted to invest more in shorter-dated securities to take advantage of the higher yields on offer. However, this strategy carries the risk that the yields on these securities will be lower when they mature, resulting in a lower overall return for the investor.

To mitigate reinvestment risk, investors can consider the following strategies:

• Be aware of which types of investments have more exposure to reinvestment risk, such as callable bonds.
• Increase the portfolio allocation to longer-duration bonds, which lock in yields for a longer period.
• Assess actively managed bond exposure.
• Consider the future interest rate environment when deciding how to invest.
• Invest in zero-coupon bonds, which do not make interest payments but trade at a discount and render full face value at maturity.
• Invest in non-callable bonds, which cannot be redeemed early by the issuer and thus have less reinvestment risk than callable bonds.
• Create a bond ladder or laddered exposure by holding a series of securities with staggered maturity dates, including short-, medium-, and long-term bonds. This diversifies the portfolio across different interest rate environments and helps manage reinvestment risk.

Overall, reinvestment risk is an important consideration for investors, particularly in the context of an inverted yield curve and when interest rates are expected to decrease. By implementing the strategies mentioned above, investors can reduce their exposure to reinvestment risk and improve their potential returns.

Prepayment penalties

Prepayment risk refers to the risk that a borrower repays their loan before the end of the loan term. This poses a problem for the lender, who will receive less interest than expected.

Prepayment risk is particularly relevant to mortgage-backed securities (MBS), where investors collect interest payments from a pool of mortgages. When a homeowner repays their loan early, the investor receives less interest than they would have done if the loan had been paid off over the full term.

To mitigate this risk, prepayment penalties are often imposed on homeowners who repay their mortgages early. These penalties are disclosed in the loan documents.

Prepayment risk is also influenced by interest rates. When interest rates fall, borrowers are incentivised to refinance their mortgages at a lower rate, which increases the prepayment risk for the original lender. Similarly, when interest rates rise, borrowers are incentivised to repay their loans more quickly to avoid higher future interest payments, which also increases prepayment risk.

Interest rates

For example, consider a borrower who takes out a floating-rate home loan. If market interest rates decrease, the borrower will be incentivised to refinance the loan into a fixed-rate home loan. This will increase the prepayment risk for the original lender, as they will receive fewer interest payments over the life of the loan.

Conversely, if interest rates increase, borrowers will be incentivised to repay their loans more quickly to avoid higher future interest payments. In this scenario, the borrower will make larger principal payments earlier, reducing future interest payments and increasing the prepayment risk for the lender.

Prepayment risk is particularly relevant in the mortgage-backed securities (MBS) market, where investors buy bundles of home loans and receive returns based on the principal and interest payments from borrowers over the lives of the loans. In this context, prepayment risk refers to the risk that borrowers will pay off their mortgages earlier than expected, reducing the total interest payments received by investors.

While changes in interest rates are a significant driver of prepayment risk, they are not the only factor. Other macroeconomic factors, such as unemployment rates and changing home valuation trends, can also influence prepayment behaviour.

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