Prepayment Risk

What is prepayment risk?

Prepayment risk is the danger that the principal on a fixed-income security will be repaid earlier than expected, causing the investor to lose future interest payments on that principal. It primarily affects securities that can be redeemed before maturity—most notably callable bonds and mortgage-backed securities (MBS).

Key takeaways

• Prepayment risk arises when borrowers or issuers repay principal early, cutting off future interest income.
• When prepayment happens, investors typically must reinvest the returned principal at prevailing market rates, which are often lower.
• The risk is most significant for callable corporate bonds and mortgage-backed securities.
• Prepayment risk makes interest-rate exposure asymmetric for investors: they can lose when rates rise but often cannot fully benefit when rates fall.

How prepayment risk works

Callable bonds include provisions that let the issuer redeem the bond before its scheduled maturity. If an issuer calls the bond, the investor receives principal back and stops receiving the contract interest payments. Noncallable bonds do not carry this risk.

In mortgage-backed securities, borrowers may refinance or repay mortgages early (for example, when interest rates fall). Those prepayments shorten the expected cash-flow stream to MBS holders and make the security’s yield-to-maturity uncertain at purchase.

Bonds bought at a premium (above par) are particularly sensitive: early repayment reduces the yield relative to the yield estimated at purchase.

Consequences for investors

• Reinvestment risk: Returned principal must be reinvested at current market rates, which may be lower than the original rate.
• One-sided interest-rate exposure: When rates rise, bond prices fall and investors suffer capital losses; when rates fall, issuers are likely to call bonds, denying investors the benefit of higher locked-in coupons.
• Uncertain total return: For MBS, unpredictable prepayment speeds make future returns difficult to forecast.
• Correlated factors: Mortgage prepayments tend to increase when interest rates fall and when home values rise (encouraging moves or cash-out refinances).

Examples

• Callable corporate bond: A company issues a bond paying a higher coupon than current market rates. If market rates decline, the company may call the bond and refinance at lower rates, leaving investors to reinvest at lower yields.
• Mortgage-backed security: Homeowners with 7% mortgages refinance when rates fall to 4–5%. The MBS investor receives principal back early and loses the remaining high-interest payments.

What makes a bond subject to prepayment risk

Only securities with call features or whose underlying loans can be prepaid carry prepayment risk. Noncallable bonds do not have this risk.

Investor considerations

• Compare callable corporate bonds and government bonds—government bonds rarely have call provisions and may be preferable in falling-rate environments, though corporate bonds can offer higher long-term returns.
• Evaluate both prepayment risk and default risk when choosing fixed-income investments.
• Look for features that mitigate prepayment risk (call protection periods, prepayment penalties, or MBS tranching) and consider the likely interest-rate environment before purchase.

Conclusion

Prepayment risk reduces the predictability of income and total return for certain fixed-income investments. Understanding which securities carry this risk, how interest-rate movements influence prepayments, and how prepayments affect reinvestment possibilities is essential for making informed fixed-income investment decisions.