Prepayment Risk

Core Description

• Prepayment Risk is the possibility that principal is returned earlier than investors expected, reducing future interest cash flows and changing the timing of returns.
• It is most visible in mortgage-backed securities (MBS) and callable bonds, where borrowers or issuers act rationally when interest rates move.
• Managing Prepayment Risk means thinking in scenarios (speed up vs. slow down), measuring prepayment “speeds,” and focusing on option-aware metrics rather than headline yield.

Definition and Background

What Prepayment Risk means in plain English

Prepayment Risk is the risk that a borrower pays back principal sooner than the bondholder or securitized-product investor assumed. Once that principal comes back, the investor stops earning interest on the repaid portion, and must reinvest the money, often at a less attractive rate if the reason for prepayment was falling interest rates.

This risk appears whenever a fixed-income cash-flow schedule is not fully controlled by the investor. Two common structures embed this uncertainty:

• Mortgage-backed securities (MBS): homeowners can refinance, sell their home, or otherwise repay the loan, causing the MBS to return principal sooner.
• Callable bonds: the issuer can redeem (call) the bond, typically when refinancing becomes cheaper.

In both cases, Prepayment Risk is best understood as an embedded option held by the borrower (in a mortgage) or by the issuer (in a callable bond). When the option is “in the money” (for example, market rates fall below the coupon rate), exercise becomes more likely.

Why it matters more when rates fall

Prepayment Risk tends to rise in declining-rate environments because refinancing incentives increase. Investors face a double impact:

1. Cash flows arrive earlier than planned (faster amortization or an unexpected call).
2. Reinvestment opportunities are weaker because prevailing yields may have declined.

This is why many investors describe Prepayment Risk as the “bad” side of optionality. Upside can be capped when rates fall, while other risks (like extension) can emerge when rates rise.

How market history made Prepayment Risk central

Prepayment Risk became a core concern as securitized mortgage markets expanded and MBS became widely held by banks, insurers, pension funds, and asset managers. In the US, repeated refinancing waves during rate cycles highlighted that borrower behavior is not constant. It reacts to rate incentives, housing turnover, underwriting quality, and frictions such as transaction costs. As a result, modern fixed-income investing increasingly treats prepayment modeling, scenario analysis, and option-adjusted valuation as standard toolkit items, not niche techniques.

Calculation Methods and Applications

Core “speed” measures: CPR, SMM, and PSA

Prepayment Risk is often summarized using standardized speed measures that help investors compare bonds or MBS pools with different characteristics.

Conditional Prepayment Rate (CPR)

CPR is an annualized measure of how quickly principal is expected to be prepaid, conditional on the loan still being outstanding. Intuitively, higher CPR implies faster expected principal return and higher Prepayment Risk for investors who want stable interest income.

Single Monthly Mortality (SMM)

SMM converts CPR into a monthly rate. A widely used relationship between CPR and SMM is:

\[\text{SMM} = 1 - (1 - \text{CPR})^{1/12}\]

SMM is practical when projecting monthly cash flows (common for MBS) because principal payments occur monthly.

PSA (Public Securities Association) benchmark

PSA is a benchmark convention used to express prepayment speeds relative to a standard path (often referred to as 100% PSA). Instead of claiming “this pool will prepay at X% CPR forever,” PSA is used to describe scenario speeds, such as 150% PSA or 50% PSA, which scale the benchmark path up or down.

A useful way to view PSA is that it is often a scenario language, not a promise or forecast.

Where these metrics get used

Prepayment Risk metrics are used across the lifecycle of a fixed-income position:

• Security selection: comparing MBS pools, callable bonds, or structured products with different embedded optionality.
• Cash-flow forecasting: projecting principal and interest distributions under different prepayment speeds.
• Risk reporting: tracking sensitivity to “speed shifts” (faster or slower prepayment) alongside interest-rate duration.
• Relative value and pricing: assessing whether a security’s yield compensates for Prepayment Risk, often via option-aware analytics.

A simple cash-flow intuition (no heavy math)

Even without building a full model, an investor can see the effect of Prepayment Risk:

• If an MBS was expected to return principal over 7 years but refinancing accelerates, principal may return in 3 to 4 years.
• That reduces the period over which the investor earns the original coupon and increases the need to reinvest sooner.
• If reinvestment yields are lower, the realized return can fall short of the initial yield estimate.

Mini-table: how “speed” changes investor outcomes

Prepayment Risk and extension risk are two sides of the same timing-uncertainty coin, especially in MBS.

Comparison, Advantages, and Common Misconceptions

Prepayment Risk vs. related concepts

Prepayment Risk vs. Call Risk

• Prepayment Risk is the broad concept: principal returns early due to borrower or issuer action.
• Call Risk is a specific form where an issuer calls a bond. For investors, call risk behaves similarly to Prepayment Risk. When rates fall, the bond is more likely to be redeemed, capping price appreciation.

Prepayment Risk vs. Reinvestment Risk

• Prepayment Risk triggers the problem (principal returns early).
• Reinvestment Risk is the consequence (the investor must reinvest at potentially lower yields).

They are closely linked, but not identical.

Prepayment Risk vs. Extension Risk

• Prepayment Risk: cash flows come back too soon.
• Extension Risk: cash flows come back too slowly (often when rates rise and refinancing slows).

Together, they contribute to the “negative convexity” behavior often associated with MBS-like cash flows.

Advantages and disadvantages: who benefits?

Borrowers and issuers

• Advantages: flexibility to refinance at lower rates, reduce borrowing cost, or adjust liabilities.
• Disadvantages: potential fees, transaction costs, or penalties (where applicable), and operational friction.

Investors

• Advantages: securities exposed to Prepayment Risk may offer additional yield or spread as compensation. In some cases, faster principal return can reduce the time the investor is exposed to certain risks.
• Disadvantages: reduced interest income, shortened asset life, reinvestment at less favorable rates, and more complex risk management.

Common misconceptions that can lead to errors

“CPR is constant, so my cash flows are predictable”

CPR is not stable across rate regimes. It tends to change with rate incentives, seasonality, home price dynamics, and refinancing capacity. Treating CPR as fixed can make yield and duration estimates misleading.

“PSA is a forecast”

PSA is often best used as a scenario convention. Treating a single PSA assumption as “the answer” can obscure how wide the range of outcomes may be.

“Only interest rates matter”

Rates are crucial, but not the only driver. Loan characteristics (coupon, vintage, documentation quality), borrower credit profile, and housing turnover can materially change prepayment behavior.

“If I know the yield, I know the risk”

Headline yield can ignore embedded optionality. Two securities can show similar yields while having very different Prepayment Risk profiles. Option-aware measures and scenario testing are typically more informative than a single yield figure.

Practical Guide

A step-by-step workflow to assess Prepayment Risk

1) Identify where the optionality sits

• In MBS, the homeowner’s ability to refinance or move is the driver.
• In callable bonds, the issuer’s right to redeem is the driver.

Ask: under what conditions would the borrower or issuer rationally prepay? Falling rates is a common trigger, but not the only one.

2) Choose a “speed” lens that matches your product

• For MBS: CPR, SMM, and PSA scenarios are commonly used for cash-flow projections and risk reporting.
• For callable bonds: focus on call schedules, call protection, and how refinancing incentives evolve.

3) Run at least 3 scenarios (slow, base, fast)

Even a simple scenario set can improve decision-making versus a single-point assumption.

• Slow prepayment scenario: a higher-rate environment or frictions reduce refinancing.
• Base scenario: a conservative midpoint assumption.
• Fast prepayment scenario: a stronger refinancing incentive and higher borrower responsiveness.

Track what changes, such as average life, principal return timeline, and the interest income stream.

4) Check what you are really being paid for

A practical question is whether the extra yield (or spread) is adequate compensation for the embedded option granted to the borrower or issuer. If not, the investor may be accepting high Prepayment Risk without sufficient compensation.

5) Monitor leading indicators over time

Prepayment Risk is dynamic. Monitoring can include:

• Market rate moves vs. mortgage rates
• Refinance incentive measures (rate differential vs. borrower’s current note rate)
• Housing turnover signals (sales volumes, mobility)
• Pool performance trends (actual prepayment speeds vs. prior assumptions)

Case Study: a simplified MBS scenario (hypothetical example, not investment advice)

Assume an investor holds an agency MBS position with $10,000,000 face value. The investor originally modeled a 6% CPR environment and expected the security’s average life to be about 6.5 years (simplified assumption for illustration).

Then market mortgage rates decline and refinancing activity increases. The investor updates scenarios:

• Base (original): 6% CPR
• Fast: 18% CPR
• Slow: 3% CPR

Using the SMM conversion for a feel of monthly impact:

\[\text{SMM} = 1 - (1 - \text{CPR})^{1/12}\]

• At 6% CPR: SMM is roughly 0.51% per month (order-of-magnitude).
• At 18% CPR: SMM is roughly 1.64% per month (order-of-magnitude).

Interpretation: in the fast scenario, a meaningfully larger share of outstanding principal returns each month. The investor receives more principal back sooner, and the interest-paying balance shrinks faster.

A simplified cash-flow consequence:

• If average life compresses from about 6.5 years to about 3.8 years under faster speeds (illustrative), the investor must reinvest principal earlier.
• If reinvestment yields are now, say, 150 to 250 bps lower than the original coupon environment (illustrative), the realized income stream can fall materially versus the initial plan.

What this demonstrates:

• Prepayment Risk is not just a “yield” issue. It is a timing issue that can change realized returns through reinvestment.
• Scenario analysis helps make a range of plausible outcomes visible before market conditions determine the outcome.

Case Study: callable bond mechanics (hypothetical example, not investment advice)

Consider a $5,000,000 corporate callable bond with:

• 10-year final maturity
• 5-year call protection
• First call at par after year 5

If market yields decline enough by year 5, the issuer has an incentive to refinance and call the bond. The investor’s best-case “hold to maturity” income may not be achievable because the bond is redeemed when reinvestment yields are less attractive. This is Prepayment Risk expressed as call risk. Principal returns early when the investor may prefer it to remain outstanding.

Resources for Learning and Improvement

High-quality primers and official research

• SIFMA primers on securitized products and MBS market structure for conventions, terminology, and product mechanics.
• Federal Reserve research on mortgage refinancing and household behavior for empirical drivers of prepayments across rate cycles.
• Rating agency methodology papers on RMBS and MBS for how prepayments are stressed in surveillance and structured-finance analysis.

Textbook-level learning paths (conceptual, not product-specific)

• Fixed-income foundations: yield curves, duration, convexity, and why embedded options change interest-rate sensitivity.
• Mortgage and structured product frameworks: cash-flow waterfalls, prepayment modeling concepts (seasoning, burnout, turnover).
• Option-aware valuation concepts: option-adjusted spread (OAS) as a way to compare securities with different embedded optionality.

Skill-building practice ideas

• Build a spreadsheet that projects monthly cash flows under 50%, 100%, and 200% PSA and compare average life outcomes.
• Track realized prepayment speeds for a sample pool and compare to your prior assumption, then note what changed (rates, seasonality, turnover).
• Practice explaining Prepayment Risk in 1 paragraph without jargon. If you can do that, you can usually communicate it well in investment teams.

FAQs

What is Prepayment Risk in 1 sentence?

Prepayment Risk is the chance that principal is repaid earlier than expected, reducing future interest income and forcing reinvestment sooner.

When is Prepayment Risk typically highest?

Prepayment Risk is often highest when interest rates fall and refinancing incentives increase, especially for mortgage-related cash flows and callable structures.

Which products are most exposed to Prepayment Risk?

Mortgage-backed securities (MBS) and callable bonds are common examples, because borrowers or issuers can alter the timing of principal repayment.

Is Prepayment Risk always negative for investors?

Not always. Faster principal return can reduce exposure time to some risks, and securities with higher Prepayment Risk may offer extra yield or spread. However, when prepayments accelerate in low-rate environments, reinvestment risk may lead to less favorable outcomes.

What is the difference between CPR and SMM?

CPR is an annualized conditional prepayment rate, while SMM expresses a monthly prepayment rate. A common conversion is \(\text{SMM} = 1 - (1 - \text{CPR})^{1/12}\).

Should I treat PSA as a prediction of what will happen?

PSA is commonly used as a scenario benchmark to describe prepayment speed assumptions. Using multiple PSA scenarios is usually more informative than relying on a single PSA number.

What is a common mistake people make with Prepayment Risk?

Relying on a single yield or a single prepayment assumption, and failing to test fast and slow scenarios, especially when rate conditions can shift quickly.

Conclusion

Prepayment Risk is fundamentally a cash-flow timing risk created by borrower or issuer flexibility. It shows up most clearly in MBS and callable bonds, and it can become more challenging when rates fall because principal returns early and must be reinvested at lower yields. A practical way to handle Prepayment Risk is to treat it as embedded optionality, measure it with standard speed tools (CPR, SMM, PSA), compare outcomes across slow, base, and fast scenarios, and use option-aware thinking rather than relying on a single headline yield.