What is Prepayment Risk?

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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.

Definition

Prepayment risk refers to the risk associated with the early repayment of principal on fixed-income securities. When a debtor repays part of the principal early, they are not required to pay interest on that portion of the principal. This means that investors in the related fixed-income securities will not receive the interest that would have been paid on the principal.

Origin

The concept of prepayment risk emerged with the development of the fixed-income securities market, particularly in the mid-20th century when products like callable bonds and mortgage-backed securities (MBS) became common. As these products gained popularity, investors began to recognize the impact that early principal repayments could have on their returns.

Categories and Features

Prepayment risk primarily affects callable bonds and mortgage-backed securities (MBS). Callable bonds allow issuers to repay debt early under certain conditions, while MBS involves the early repayment of mortgages. The main feature of prepayment risk is that investors may lose future interest income, especially when interest rates fall, as debtors are more likely to repay early to refinance.

Case Studies

A typical case occurred during the 2008 financial crisis when mortgage rates in the U.S. dropped significantly, leading many homeowners to repay their mortgages early. This had a major impact on investors holding MBS, as they lost expected interest income. Another case involves companies choosing to call their issued callable bonds early when interest rates fall, allowing them to refinance at lower rates, which also results in investors losing potential interest income.

Common Issues

Investors often misunderstand prepayment risk, thinking it only occurs when interest rates rise. In reality, prepayment risk is more pronounced when interest rates fall, as debtors are more motivated to repay early. Additionally, investors may underestimate the impact of prepayment penalties, which can partially offset the losses from early repayment.

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