What is a Conditional Prepayment Rate - CPR
A conditional prepayment rate (CPR) is a loan prepayment rate equivalent to the proportion of a loan pool's principal that is assumed to be paid off ahead of time in each period. The calculation of this estimate is based on a number of factors, such as historical prepayment rates for previous loans similar to ones in the pool and future economic outlooks.
BREAKING DOWN Conditional Prepayment Rate - CPR
The CPR can be used for a variety of loans. For example, mortgages, student loans and pass-through securities all use CPR as estimates of prepayment. Typically, CPR is expressed as a percentage. For example, a pool of mortgages with a CPR of 8% indicates that for each period, 8% of the pool's outstanding principal will be paid off. The CPR represents the anticipated paydown rate, stated as a percentage and calculated as an annual rate. It is often used for securities backed by debts, such as mortgage-backed securities (MBS), where a prepayment by the associated debtors may result in lower returns.
The higher the CPR, the faster the associated debtors prepay on their loans. The CPR can be converted to a single monthly mortality rate (SMM). The SMM is determined by taking the total debt payment owed and comparing it against the actual amounts received. For example, if the total debt outstanding is $1 million and the payment owed for the month is $100,000 across all of the associated mortgages, but when the payments were received the actual total was $110,000, that reflects an SMM of 1%.
Conditional Prepayment Rate Pros and Cons
A high prepayment rate means the debts associated with the security are being paid back at a faster rate than the required minimum. While this indicates the investment is lower risk, since the amount owed is being paid back, it also leads to lower rates of returns.
Often, debtors prepay their debts to refinance them for a lower rate. If that occurs, the bond is paid back faster than expected and released back to the investor. The investor needs to choose a new security to invest in, which may have a lower rate of return due to the lower interest rates associated with the debts backing the particular security.
Corporate Bonds, Treasury Bonds and other Lower CPR Risk Investments
There is no risk of CPR with corporate bonds or Treasury bonds (T-bonds), as these do not allow for prepayment. Additionally, investments in collateralized mortgage obligations (CMOs) and collateralized debt obligations (CDOs), structured through investment banks, lower the prepayment risk by design. Further, those associated with a higher-risk tranche often have a longer lifespan than those with a lower-risk tranche, resulting in a longer investment period before repayment of the initial investment is returned.