Prepayment risk is the risk involved with the premature return of principal on a fixed-income security. When principal is returned early, future interest payments will not be paid on that part of the principal, meaning investors in associated fixed-income securities will not receive interest paid on the principal. The risk of prepayment is most prevalent in fixed-income securities such as callable bonds and mortgage-backed securities (MBS).
Breaking Down Prepayment Risk
Prepayment risk exists in some fixed-income securities with embedded call options that may be exercised by the issuer, or in the case of a mortgage-backed security, the borrower. These options give the issuer the right, but not the obligation, to redeem the bond before its scheduled maturity. In mortgage-backed security, 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 not certain, 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 what was estimated at the time of purchase.
Prepayment Risk in 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.
Examples of Prepayment Risk
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. On 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. That's because rising home values provide an incentive for borrowers to trade up in homes or use cash-out refinances, both leading to mortgage prepayments.