What Is Prepayment Risk?

Prepayment risk is the risk involved with the premature return of principal on a fixed-income security. When debtors return part of the principal early, they do not have to make interest payments on that part of the principal. That means investors in associated fixed-income securities will not receive interest paid on the principal. The prepayment risk is highest for fixed-income securities, such as callable bonds and mortgage-backed securities (MBS). Bonds with prepayment risk often have prepayment penalties.

Key Takeaways

  • Prepayment risk is the risk involved with the premature return of principal on a fixed-income security.
  • When prepayment occurs, investors must reinvest at current market interest rates, which are usually substantially lower.
  • Prepayment risk mostly affects corporate bonds and mortgage-backed securities (MBS).
  • Prepayment risk can stack the deck against investors by making interest rate risk one-sided.

Understanding Prepayment Risk

Prepayment risk exists in some callable fixed-income securities that may be paid off early by the issuer, or in the case of a mortgage-backed security, the borrower. These features give the issuer the right, but not the obligation, to redeem the bond before its scheduled maturity.

With a callable bond, the issuer has the ability to return the investor's principal early. After that, the investor receives no more interest payments. Issuers of noncallable bonds lack this ability. 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.

For mortgage-backed securities, mortgage holders may refinance or pay off their mortgages, which results in the security holder losing future interest. Because the cash flows associated with such securities are uncertain, their yield-to-maturity cannot be known for certain at the time of purchase. If the bond was purchased at a premium (a price greater than 100), the bond's yield is then less than the one estimated at the time of purchase.

Criticism of Prepayment Risk

The core problem with prepayment risk is that it can stack the deck against investors. Callable bonds favor the issuer because they tend to make interest rate risk one-sided. When interest rates rise, issuers benefit from locking in low rates. On the other hand, bond buyers are stuck with a lower interest rate when higher rates are available. There is an opportunity cost when investors buy and hold bonds in a rising rate environment. From a total return perspective, bondholders also suffer a capital loss when interest rates rise.

When interest rates fall, investors only benefit if the bonds are not called. As market interest rates go down, the bondholders gain by continuing to receive the old interest rate, which was higher. Investors can also sell the bonds to obtain a capital gain. However, issuers will call their bonds and refinance if interest rates decline substantially, eliminating the possibility for bondholders to benefit from rate changes. Investors in callable bonds lose when interest rates rise, but they can't win when rates fall.

As a practical matter, corporate bonds often have call provisions, while government bonds rarely do. That is one reason why investing in government bonds is often a better bet in a falling interest rate environment. However, corporate bonds still have higher returns in the long run.

Investors should consider prepayment risk, as well as default risk, before choosing corporate bonds over government bonds.

Requirements for Prepayment Risk

Not all bonds have prepayment risk. If a bond cannot be called, then it does not have prepayment risk. 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 the period, it returns the investor's principal. Bonds can either be callable or noncallable.

Examples of Prepayment Risk

For a callable bond, the higher a bond's interest rate relative to current interest rates, the higher the prepayment risk. With mortgage-backed securities, the probability that the underlying mortgages will be refinanced increases as current market interest rates fall further below the old rates.

For example, a homeowner who takes out a mortgage at 7% has a much stronger incentive to refinance after rates drop to 4% or 5%. When and if the homeowner refinances, those who invested in the original mortgage on the secondary market do not receive the full term of interest payments. If they wish to keep investing in the mortgage market, they will have to accept lower interest rates or higher default risk.

Investors who purchase 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. That's because rising home values provide an incentive for borrowers to trade up their homes or use cash-out refinances, both of which lead to mortgage prepayments.