What Does Average Life Mean?
The average life is the length of time the principal of a debt issue is expected to be outstanding. The average life is an average period before a debt is repaid through amortization or sinking fund payments. To calculate the average life, multiply the date of each payment (expressed as a fraction of years or months) by the percentage of total principal that has been paid by that date, add the results and divide by the total issue size.
Average Life Explained
Also called the weighted average maturity and weighted average life, the average life is calculated to determine how long it will take to pay the outstanding principal of a debt issue, such as a T-bill or bond. While some bonds repay the principal in a lump sum at maturity, others repay the principal in installments over the term of the bond. In cases where the bond's principal is amortized, the average life allows investors to determine how quickly the principal will be repaid.
The payments received are based on the repayment schedule of the loans backing the particular security, such as with mortgage-backed securities (MBS) and asset-backed securities (ABS). As borrowers make payments on the associated debt obligations, investors are issued payments reflecting a portion of these cumulative interest and principal payments.
Calculating the Average Life on a Bond
For example, assume an annual-paying four-year bond has a face value of $200 and principal payments of $80 during the first year, $60 for the second year, $40 during the third year and $20 for the fourth (and final) year. The average life for this bond would be calculated with the following formula:
Average life = 400 / 200 = 2 years
This bond would have an average life of two years against its maturity of four years.
Mortgage-Backed and Asset-Backed Securities
In the case of an MBS or ABS, the average life represents the average length of time required for the associated borrowers to repay the loan debt. An investment in an MBS or ABS involves purchasing a small portion of the associated debt that is packaged within the security.
The risk associated with an MBS or ABS centers on whether the borrower associated with the loan will default. If the borrower fails to make a payment, the investors associated with the security will experience losses. In the financial crisis of 2008, the large number of defaults on home loans, particularly in the subprime market, led to significant losses in the MBS arena.