bankingciooutlook

What Is Prepayment Risk?

Banking CIO Outlook | Wednesday, April 14, 2021

Mortgage holders will refinance or pay off their mortgages on mortgage-backed securities, causing the security holder to lose future interest.


Fremont, CA: The risk of a fixed-income security's principal being returned early is known as prepayment risk. Debtors who return a portion of the principal early do not have to pay interest on that portion of the principal. As a result, investors in similar fixed-income securities will not be paid interest on their principal. Fixed-income securities, such as callable bonds and mortgage-backed securities, have the highest prepayment risk (MBS). Prepayment penalties are common in bonds with a prepayment chance.

Any callable fixed-income securities, such as mortgage-backed securities, bear the risk of being paid off early by the issuer or, in the case of a mortgage-backed bond, the borrower. These features offer the borrower the opportunity to redeem the bond before its scheduled maturity date, but not the requirement to do so.

The issuer of a callable bond has the option of returning the investor's principal early. The lender can no longer collect interest payments after that. Noncallable bond issuers do not have this potential. As a result, callable bonds are only correlated with prepayment risk, which explains the risk of the issuer returning principal early and the holder losing out on subsequent interest.

Mortgage holders will refinance or pay off their mortgages on mortgage-backed securities, causing the security holder to lose future interest. Since the cash flows associated with such securities are unpredictable, the yield-to-maturity of such securities cannot be predicted with certainty at the time of acquisition. The bond's yield is less than the one expected at the time of purchase if it was bought at a premium.

The main issue with prepayment risk is that it can put investors at a disadvantage. Since callable bonds appear to make interest rate risk one-sided, they benefit the issuer. Issuers profit from locking in low rates as interest rates increase. Bond investors, on the other hand, are locked into a lower interest rate when higher rates are open. When investors buy and keep bonds in a - rate-setting, they incur an opportunity cost. Bondholders incur a capital loss as interest rates increase from a total return standpoint.

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