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 that 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.
BREAKING DOWN 'Prepayment Risk'
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 is then less than what was estimated at the time of purchase.
Callable vs. Noncallable Bonds
A bond is a debt investment in which an entity borrows money from an investor. The entity makes regular interest payments to the investor throughout the bond's maturity period, at the end of which it returns the investor's principal.
Bonds can either be callable or noncallable. With a callable bond, the issuer has the option to return the investor's principal early, after which the investor receives no more interest payments. Issuers of noncallable bonds lack this option. Consequently, prepayment risk, which describes the chance of the issuer returning principal early and the investor missing out on subsequent interest, is only associated with callable bonds.
Why Bonds Get Called
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.
For example, a homeowner who takes out a mortgage at 7% has a much stronger incentive to refinance when rates drop to 4 or 5% versus when rates stay at 7% or go higher. When and if the homeowner refinances, those who invested in his original mortgage on the secondary market do not receive the full term of interest payments for which they were hoping.
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.