A Different Sort of Bond: Prepayment Rates and Average Lives
With fixed-income securities such as corporate or Treasury bonds, the purchase of a bond from an issuer is essentially a loan to the issuer in the amount of the principal, or face value, of the bond for a prescribed period of time. In return for this loan, the bondholder receives interest, generally in semiannual payments, until the bond is redeemed. When the bond matures or is called by the issuer, the issuer returns the face value of the bond to the investor in a single principal payment.
Although mortgage securities are fixed-income securities that entitle investors to payments of principal and interest, they differ from corporate and Treasury securities in significant ways. With a mortgage security, the ultimate borrower is the homeowner who takes on a mortgage loan. Because the homeowner’s monthly payments include both interest and principal, the mortgage security investor’s principal is returned over the life of the security, or amortized, rather than repaid in a single lump sum at maturity. Mortgage securities provide payments to investors that include varying amounts of both principal and interest. As the principal is repaid, or prepaid, interest payments become smaller because they are based on a lower amount of outstanding principal. In addition, while most bonds pay interest semiannually, mortgage securities may pay interest and principal monthly, quarterly or semiannually, depending on the structure and terms of the issue.
A mortgage security matures when the investor receives the final principal payment. Both mortgage pass-through securities and CMO tranches have a stated maturity based on the last date on which the principal from the collateral is scheduled to be paid in full. This date is theoretical because it assumes no prepayments on the underlying mortgage loans. Most mortgage pass-through securities are based on fixed-rate mortgage loans with an original maturity of 30 years, but typically most of these loans will be paid off much earlier.
Prepayment. The cashflow on mortgage securities is somewhat irregular because the timing and speed of principal repayments may vary. Typically, a mortgage borrower can prepay the mortgage loan by selling the property, refinancing the mortgage, paying off the loan in part or in whole, or defaulting on their loans. When this happens, the investors’ remaining interest in the pool is reduced by the prepayment amount. Because the principal is reduced over the life of the security, the interest income also decreases in terms of absolute dollars paid to investors. In the case of CMOs, investors receive these principal repayments according to the payment priorities of the class of securities they own.
Prepayment assumptions are estimates of expected prepayments. Industry standard and various proprietary prepayment rate models exist. Their assumptions may be based on historic prepayment rates for each particular type of mortgage loan, various economic conditions and geographical locations of the specific properties, among other factors. These assumptions are factored into the offering price, yield, and market value of a mortgage security. The realization of the average life and yield estimates depends on the accuracy of the prepayment assumptions. A common way of expressing prepayment rates is in terms of the Standard Prepayment Model of the Securities Industry and Financial Markets Association (SIFMA). Developed in 1985 for mortgage securities, SIFMA’s model assumes that new mortgage loans are less likely to be prepaid than older, “seasoned” mortgage loans. Projected and historical prepayment rates are often expressed as percentage of Prepayment Speed Assumptions (PSA). Other common measures of prepayment speeds include the ‘conditional prepayment rate’ (CPR) and ‘single monthly mortality’ (SMM).
Average Life. Average life is the average time that each dollar of principal in the pool is expected to be outstanding, based on certain prepayment assumptions. Because of the ability of borrowers to prepay the underlying mortgage loans, mortgage securities are often discussed in terms of their average life rather than their stated maturity date. If prepayment speeds are faster than expected, the average life of the mortgage security will be shorter than the original estimate; if prepayment speeds are slower, the mortgage security’s average life will be extended. In the case of CMOs, some tranches are specifically designed to minimize the effects of a variable prepayment rate. As is the case of all mortgage securities, the average life of the security is always an estimate at best, contingent on how closely the actual prepayment speeds of the underlying mortgage loans match assumptions.
All information and opinions contained in this publication were produced by the Securities Industry and Financial Markets Association from our membership and other sources believed by the Association to be accurate and reliable. By providing this general information, the Securities Industry and Financial Markets Association makes neither a recommendation as to the appropriateness of investing in fixed-income securities nor is it providing any specific investment advice for any particular investor. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and sources may be required to make informed investment decisions.