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Types of Bonds

Prepayment Models

Investors in ABS are typically concerned about the likelihood and extent of prepayment. That is, they worry about receiving all or part of the principal of the underlying debt before it is due (in the case of amortizing assets) or before it is expected (in the case of nonamortizing assets). Determining the most likely prepayment scenario is critical to making an investment decision with a reasonable expectation about a security’s life—which, in turn, affects the likely yield.

What follows are explanations of the key prepayment conventions used by the ABS market. Investors should bear in mind that prepayment models do not predict actual prepayment behavior, but instead provide a common methodology for expressing prepayment activity. Moreover, since the ABS market has existed only since the mid-1980s, prepayment models, which are based on historical performance, are likely to evolve further.

Constant Prepayment Rate (CPR)

Also known as conditional prepayment rate, the CPR measures prepayments as a percentage of the current outstanding loan balance. It is always expressed as a compound annual rate—a 10% CPR means that 10% of the pool’s current loan balance pool is likely to prepay over the next year. The CPR is commonly used to describe the prepayment experience of HELs and student-loan assets.

Monthly Payment Rate (MPR)

Technically, this is not a prepayment measure, because it is used with nonamortizing assets, such as credit card and dealer floor-plan receivables, which are not subject to prepayment. Rather, the MPR is a repayment measure and is calculated by dividing the sum of the interest and principal payments received in a month by the outstanding balance. The rating agencies require every nonamortizing ABS issue to establish a minimum MPR as an early-amortization trigger event; if repayments drop to that level, the security enters into early amortization. (See “Early-Amortization Risk,” on page 20.)

Absolute Prepayment Speed (ABS)

This abbreviation (which, confusingly, is the same as that used for asset-backed securities) is commonly applied to securities backed by auto loans, truck loans, RV loans and auto leases. Unlike CPR, which measures prepayments as a percentage of the current outstanding loan balance, the ABS calculates them as a monthly percentage of the original loan balance.

Home-Equity Prepayment Curve (HEP)
The HEP curve is a prepayment scale (ranging from 0% to 100%) for HELs that captures the more rapid plateau for home-equity prepayments vis-a-vis that of traditional mortgages. It is a 10-month seasoning ramp with even step-ups, terminating at the final HEP percentage in the 10th month. The standard HEP is 20%; it equals 2% CPR in the first month, 4% in the second month, 6% in the third month and so on until it levels off at 20% CPR in the 10th month.

Prospectus Prepayment Curve (PPC)

Sometimes called the pricing prepayment curve, the PPC is a relatively new convention, used mainly with HELs. It refers to the pricing speed of a transaction as defined in the prospectus and is always issue-specific. Issues are normally priced at 100% PPC, but comparisons among deals can be difficult because PPC may be defined differently in each security’s prospectus.

Manufactured-Housing Prepayment Curve (MHP)

A prepayment scale with a 24-month seasoning ramp, MHP is often used in the manufactured-housing sector. Thus, 100% MHP equals a starting rate of 3.7% CPR in the first month, stepping up 0.1% per month until the 24th month, after which it remains constant at 6% CPR. Most securities have recently been priced at 150% to 200% MHP (that is, 5.6% CPR in the first month, rising to 9% CPR in the 24th month).

 

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.