{ "id": "1d595340-0df2-59ac-9be2-6ac0deb421fa", "slug": "prepayment-risk", "term": "Prepayment Risk", "aliases": [], "category": "Fixed Income", "category_slug": "fixed-income", "difficulty": "intermediate", "definition": "Prepayment risk is the risk faced by mortgage-backed securities (MBS), callable bonds, and other fixed-income instruments with embedded prepayment options that borrowers or issuers will repay principal faster than expected—typically when interest rates fall—forcing investors to reinvest at lower prevailing rates and shortening the duration of the investment below what was initially expected. It is the primary source of negative convexity in fixed-income portfolios.", "key_takeaways": [ "Prepayment risk is greatest for mortgage-backed securities, where homeowners refinance their mortgages when rates fall, causing early principal return to MBS investors.", "Contraction risk occurs when prepayments accelerate in falling rate environments; extension risk is the mirror image, when prepayments slow in rising rate environments.", "Prepayment rates are measured using the Conditional Prepayment Rate (CPR) or the PSA (Public Securities Association) model, which provides standardized prepayment speed benchmarks.", "MBS instruments are structured into tranches with different prepayment exposure: Planned Amortization Class (PAC) bonds absorb stable prepayments, while support/companion tranches bear volatile prepayment risk.", "Negative convexity—the tendency for MBS prices to underperform pure duration-equivalent Treasuries when rates fall—directly results from prepayment risk." ], "detailed_explanation": "Prepayment risk is a defining characteristic of mortgage-backed securities and the primary reason why MBS analysis requires specialized analytics beyond those used for traditional corporate or government bonds. When interest rates decline, homeowners have the incentive to refinance their existing mortgages at lower rates—an economically rational exercise of the embedded prepayment option in their mortgage contracts. This refinancing activity causes the principal balances in mortgage pools to amortize faster than originally scheduled, returning cash to MBS investors at precisely the time when reinvestment rates are lowest.\n\nThe impact of prepayments on MBS valuation is captured through the concept of option-adjusted spread (OAS), which removes the value of the embedded prepayment option from the quoted yield spread. A mortgage-backed security yielding 150 basis points over Treasuries might have an OAS of only 90 basis points if 60 basis points of the spread compensates for the value of the prepayment option granted to borrowers. The OAS framework allows investors to compare MBS against other fixed-income instruments on an option-adjusted basis, providing a more meaningful measure of relative value.\n\nPrepayment modeling is one of the most complex disciplines in fixed-income analysis. Prepayment speeds depend on a range of factors beyond simple rate incentives: the 'burnout' effect (pools that have already experienced high refinancing activity in previous rate cycles have less refinancing potential remaining), seasonal patterns (home purchases and refinancings peak in spring and summer), demographic factors (loan age, borrower income, credit quality), and housing market conditions (home price appreciation enables cash-out refinancing even without rate incentives). Major prepayment models, including those from Andrew Davidson & Co, Citigroup, and Bank of America, incorporate hundreds of variables to forecast prepayment vectors across rate scenarios.\n\nThe CMO (Collateralized Mortgage Obligation) structure was developed specifically to redistribute prepayment risk among investors with different preferences. PAC (Planned Amortization Class) bonds provide highly predictable cash flows within a specified band of prepayment speeds (the 'collar'), supported by companion or support bonds that absorb the prepayment variability outside the collar. TAC (Targeted Amortization Class) bonds protect against extension risk only. Sequential-pay structures prioritize the principal repayment sequence, allowing investors to select their preferred tranche based on expected average life and prepayment risk tolerance. These structural innovations transformed the prepayment risk management toolkit but did not eliminate the underlying risk—they merely redistributed it among investors with different price sensitivities.\n\nFor portfolio managers, prepayment risk interacts critically with duration management. An MBS portfolio targeted at a 5-year duration will shorten significantly (perhaps to 3 years) if prepayments accelerate due to a 200bp rate decline—at precisely the time the manager most wants long duration to benefit from the rate decrease. This negative convexity requires active duration management and creates significant hedging complexity. Agency MBS desks at large fixed-income managers continuously hedge prepayment-induced duration changes using Treasury futures, interest rate swaps, and swaptions.", "example": "A fixed-income fund purchases $100 million of agency MBS backed by 30-year 6.5% mortgages at a price of $102 (premium MBS). The CPR assumption at purchase is 10% annually (100 PSA). The fund models that the weighted average life (WAL) is 7 years at this prepayment speed. Interest rates fall 150 basis points over the next year, causing refinancing activity to surge. The CPR rises to 35% (350 PSA). The WAL of the remaining portfolio collapses to 3.5 years. The fund paid a premium for these mortgages ($102 versus $100 par) and now that premium amortizes much faster than expected—an accelerated 'premium amortization' that reduces effective yield below the stated coupon. Additionally, the principal returned must be reinvested at the new, lower rates. The manager must buy additional 10-year Treasuries to rebalance portfolio duration, incurring transaction costs and market impact—a real-world illustration of prepayment risk's portfolio management implications.", "formula": "CPR (Conditional Prepayment Rate) = 1 - (1 - SMM)^12, where SMM = Single Monthly Mortality (fraction of remaining balance prepaid in a given month)", "formula_latex": null, "interactive_type": "model", "calculator_id": null, "related_terms": [ "basis", "bullet-bond", "cdo-squared", "collar", "collateralized-loan-obligation", "collateralized-mortgage-obligation", "convexity", "duration", "extension-risk", "hedging", "interest-rate", "macaulay-duration", "market-impact", "mortgage-backed-security", "negative-convexity" ], "backlinks": [ "credit-rating", "excess-spread", "reinvestment-risk", "treasury-bond" ], "cross_references": [ "basis", "collar", "collateralized-mortgage-obligation", "convexity", "duration", "extension-risk", "hedging", "interest-rate", "market-impact", "mortgage-backed-security", "negative-convexity", "option", "option-adjusted-spread", "premium", "relative-value", "speed", "tranche", "yield" ], "tags": [ "level:intermediate", "cat:fixed-income" ], "asset_classes": [ "fixed-income" ], "regulators": [], "see_also": [], "sources": [], "wordcount": 824, "checksum": "2e1ea44fbdf043ca", "version": "2026.05.03", "license": "CC-BY-4.0", "updated_at": "2026-09-07T02:15:24+00:00", "_links": { "self": "https://hedgefund.wiki/api/v1/terms/prepayment-risk", "jsonld": "https://hedgefund.wiki/api/v1/terms/prepayment-risk?format=jsonld", "markdown": "https://hedgefund.wiki/api/v1/terms/prepayment-risk?format=md", "graph": "https://hedgefund.wiki/api/v1/graph/prepayment-risk", "category": "https://hedgefund.wiki/api/v1/categories/fixed-income", "schema": "https://hedgefund.wiki/schema/term.schema.json", "html": "https://hedgefund.wiki/#/terms/prepayment-risk" } }