- For a prefunded deal, if the prefunded amount is not fully spent by the prefunding deadline, say three months after settlement, then the excess prefunding cash is effectively a prepayment that pays down the bonds. This will shorten the bonds and may lessen their yield. In general, if a bond is purchased at a premium and pays down faster than anticipated, then the yield will be lower than anticipated.
- When prefunding assets, the assets purchased may differ slightly from the characteristics stipulated in the the prospectus. This difference should be small and not impact the performance of the deal. A similar risk is inherent in an actively managed collateralized debt obligation (CDO).
- A prepayment option is the ability of a borrower to pay down his loan faster than the scheduled amortization. Various ABS loans have prepayment risk to different degrees: mortgages, student loans, auto loans, and the like. In general, prepayment risk is the relative devaluation of a prepayable bond compared to a nonprepayable bond. Consider a par bond. Interest rates prepayments excess cash needs to be reinvested at lower rates. Interest rates prepayments weighted-average life (WAL) cash stuck in low-yield investment. In both cases, a prepayable bond’s value decreases relative to that of a nonprepayble bond, all other things being equal. This is negative convexity, as illustrated in Figure .
- Another way to look at the economics of prepayments is the same reasoning given under “Prefunding” above. If a bond is purchased at a premium and pays down faster than anticipated then the yield will be lower than anticipated. If a bond is purchased at a discount and pays down slower than anticipated then the yield will also be lower than anticipated. These are sometimes called contraction and extension risks.
- For mortgages, prepayments can generally be discouraged by charging a prepayment penalty. However, the inverse relationship between prepayment penalty and prepayment rate is not guaranteed. Prepayment penalty cash flows contribute directly to the residual, not the issued bonds.
- Prepayment rates are a function of market interest rates. For fixed-rate loans if the market rate decreases below the loan’s fixed rate then the probability of that loan’s prepayment increases. If the market rate increases above the loan’s fixed rate then the probability of that loan’s prepayment decreases. During their fixed-rate period, hybrid adjustable-rate mortgage (ARM) loans act like fixed-rate loans with respect to prepayment rates. Also, upon its first reset, an ARM has a greater probability of defaulting should market rates have increased beyond the loan’s initial fixed rate (“reset shock”).