Prepayment Risk

What is 'Prepayment Risk'

Prepayment risk is the risk associated with the early unscheduled return of principal on a fixed-income security. Some fixed-income securities, such as mortgage-backed securities, have embedded call options which may be exercised by the issuer, or in the case of a mortgage-backed security, the borrower.

The yield-to-maturity of such securities cannot be known for certain at the time of purchase since the cash flows are not known. When principal is returned early, future interest payments will not be paid on that part of the principal. If the bond was purchased at a premium (a price greater than 100) the bond's yield will be less than what was estimated at the time of purchase.

BREAKING DOWN 'Prepayment Risk'

For a bond with an embedded call option, the higher a bond's interest rate relative to current interest rates, the higher the prepayment risk.

For example, on a mortgage-backed security, the higher the interest rate relative to current interest rates, the higher the probability that the underlying mortgages will be refinanced. Investors who pay a premium for a callable bond with a high interest rate take on prepayment risk. In addition to being highly correlated with falling interest rates, mortgage prepayments are highly correlated with rising home values, as rising home values provide incentive for borrowers to trade up in homes or use cash-out refinances, both leading to mortgage prepayments.

RELATED TERMS
  1. Portfolio Runoff

    A decrease in the assets of a mortgage-backed securities portfolio ...
  2. Refinancing Risk

    1. The risk that an early unscheduled repayment of principal ...
  3. Constant Percent Prepayment

    Annualized estimate of mortgage loan prepayments, computed by ...
  4. Dealer-Median Prepayment Speed

    The median value of all Wall Street securities dealers' prepayment ...
  5. Single Monthly Mortality - SMM

    In mortgage-backed securities (MBSs), this is the percentage ...
  6. Prepayment

    The satisfaction of a debt or installment payment before its ...
Related Articles
  1. Professionals

    Mortgage-Backed Securities (MBS)

    CFA Level 1 - Mortgage-Backed Securities (MBS). Learn the process of creating and collateralizing mortgage-backed securities. Covers their expected cash flows and possible risks.
  2. Bonds & Fixed Income

    The Risks Of Mortgage-Backed Securities

    Find out how weighted average life guards against prepayment risk.
  3. Term

    What's the Option-Adjusted Spread?

    The option-adjusted spread, or OAS, measures a fixed-income security rate’s spread and the risk-free rate of return that’s adjusted to account for an embedded option.
  4. Professionals

    Collateralized Mortgage Obligations (CMOs)

    FINRA Series 7 Online Study Guide Section 4
  5. Professionals

    Call and Prepayment Risk

    CFA Level 1 - Call and Prepayment Risk. Learn the sources of call and prepayment risk and why it can occur. Highlights the disadvantages of investing in prepayable or callable bonds.
  6. Retirement

    Analyzing The Best Retirement Plans And Investment Options: Bonds

    What they are: Debt securities in which you lend money to an issuer (such as a corporation or government) in exchange for interest payments and the future repayment of the bond’s face value. ...
  7. Professionals

    Mortgage-Backed Securities

    Mortgage-Backed Securities
  8. Investing

    What are Fixed-Income Securities?

    For a fixed-income security, the periodic return on the investment is the same throughout the life of the security. Principal is returned at the time of maturity. The payment can be in the form ...
  9. Investing

    3 Major Risks For Annaly’s Investors

    Thanks to its double-digit dividend yield, Annaly Capital Management has long been a favorite among income-seeking investors.
  10. Credit & Loans

    How To Become a Mortgage-Backed Securities Analyst

    Specializing in structured or derivative credit products like mortgage-backed securities requires education and prior experience in the mortgage field.
RELATED FAQS
  1. What is the difference between an option-adjusted spread and a Z-spread in reference ...

    Learn about the difference between the Z-spread and option-adjusted spread valuations of future cash flows for bonds, and ... Read Answer >>
  2. What are the best ways to invest in mortgage-backed securities (MBS)?

    Find out how you can start investing in real estate through mortgage-backed securities. Read Answer >>
  3. How does an investor make money on bonds?

    Bonds are part of the family of investments known as fixed-income securities. These securities are debt obligations, meaning ... Read Answer >>
  4. Do prepayments provide working capital?

    Learn how prepayments for various services such as insurance, rent and supplies are included as part of a company's current ... Read Answer >>
  5. What are the main disadvantages of fixed income securities?

    Learn why fixed-income securities, despite offering the luxury of guaranteed, regular cash payments, confer several disadvantages ... Read Answer >>
  6. What are the biggest risks of fixed-income investing?

    Learn about the three biggest risks of bonds and other fixed-income investments. Find out more about related issues and learn ... Read Answer >>
Hot Definitions
  1. Law Of Demand

    A microeconomic law that states that, all other factors being equal, as the price of a good or service increases, consumer ...
  2. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  3. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  4. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  5. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  6. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
Trading Center