Prepayment risk arises when borrowers make extra principal repayments ahead of schedule. It is most notable in securities with prepayment options, such as mortgage-backed securities (MBS) and other loans with call or prepayment features. When prepayments occur, the investor receives principal sooner than anticipated, which can shorten the security's average life and reduce future interest income. The risk is influenced by factors such as prevailing interest rates, refinancing incentives, and housing market activity. Prepayments can also alter the instrument's duration and convexity, two measures used to estimate sensitivity to interest rate changes.
Investors incorporate prepayment risk into valuation, risk assessment, and income planning. Models often use prepayment rate assumptions, such as the Prepayment Speed (PSA) benchmark, to forecast cash flows under different rate scenarios. Higher expected prepayments tend to shorten duration and affect reinvestment risk, since the cash may be reinvested at lower yields. In portfolios containing prepayable instruments, managers compare securities using metrics that reflect anticipated prepayment behavior, such as option-adjusted spread (OAS) and effective duration. Prepayment risk interacts with other risks, including credit risk and liquidity risk, and is a key consideration in the analysis of mortgage-related or callable instruments.
For example, when prevailing rates decline, borrowers may refinance, causing faster-than-expected principal repayments on an MBS and shortening its assumed life.
Mortgage-backed securities (MBS) · Callable bond · Reinvestment risk · Prepayment speed (PSA) · Option-adjusted spread (OAS) · Duration