What Is Contraction Risk?

Contraction risk is a type of risk faced by holders of fixed-income securities. It refers to the risk that the debtor might pay back the money borrowed more quickly than anticipated, thereby reducing the amount of future interest income received by the security holder. Contraction risk is therefore a component of prepayment risk.

This type of risk increases as interest rates decline. This is because declining interest rates might incentivize borrowers to prepay some or all of their outstanding debts in order to refinance at lower interest rates.

Key Takeaways

  • Contraction risk refers to the risk that a borrower will repay their debts ahead of schedule.
  • This would lead to the term of the loan being shorter than expected.
  • Such prepayments can hurt investors by depriving them of their expected interest revenues.

How Contraction Risk Works

Investors who purchase fixed-income securities are purchasing a stream of future interest and principal payments from a debtor. For instance, owners of mortgage loans are entitled to the payments made by a homeowner, whereas owners of corporate bonds receive their payments from a corporate borrower. In either case, the holder of the security is expecting the borrower to pay them back gradually over the term of the loan—such as 25 years in the case of a 25-year mortgage.

If the borrower were to repay the loan more quickly than expected, this creates a problem for the security holder. This is because the security holder now must reinvest the repaid loan amount in some other investment vehicle. If interest rates have declined since the original loan was given, the investor might not be able to find new investments that offer a comparable rate of return. This can lead to the investor receiving a less attractive return than they initially planned for.

For fixed-rate loans, contraction risk typically comes into play in declining interest rate environments, because borrowers may be tempted to refinance their loans using the new, lower rates. When rates are rising, however, fixed-rate borrowers will have no incentive to prepay on their loans. In the case of variable-rate loans, however, borrowers may be tempted to prepay early if rates rise or fall. After all, if rates rise during the term of their loan, they may wish to accelerate their payments in order to avoid paying higher interest in the future.

Real World Example of Contraction Risk

To illustrate, consider a financial institution that offers a mortgage at an interest rate of 5 percent. That financial institution expects to earn interest on that investment for the 30-year life of the mortgage. However, if the interest rate declines to 3 percent, the borrower may refinance the loan, or accelerate payments. This prepayment reduces the number of years that they will pay interest to the investor. The borrower benefits by doing so because they will ultimately pay less in interest over the lifespan of the loan. The mortgage owner, however, ends up with a lower rate of return than initially expected. 

Contraction risk, which typically takes place when interest rates decline, is the counterpart to extension risk, which usually takes place when interest rates increase. Whereas contraction risk happens when borrowers pre-pay a loan, shortening its duration, extension risk occurs when they do the opposite—they defer loan payments, increasing the length of the loan.