Prepayment Risk
Definition
The risk that borrowers repay principal faster than scheduled, forcing investors to reinvest proceeds at potentially lower yields. Prepayment risk is highest in mortgage-backed securities (MBS) and asset-backed securities (ABS) backed by amortizing loans with prepayment optionality. When rates fall, borrowers refinance, prepaying high-coupon loans and leaving investors with principal to reinvest at lower rates.
Why it matters
Prepayment risk creates negative convexity in MBS—when rates fall, bond prices rise less than expected (or even fall) because investors receive principal back and lose high coupons. This explains why agency MBS trade at spreads of 40-80bps over Treasuries despite minimal credit risk—investors demand compensation for prepayment uncertainty. Understanding prepayment dynamics is critical for MBS valuation, especially in volatile rate environments. During 2020-2021 refi boom, MBS investors received massive principal returns at par, forcing reinvestment at 1-2% yields vs. 3-4% original coupons.
Common misconceptions
- •A structural protection is not a guarantee; it reallocates cash, timing, discretion, or losses according to the deal documents.
- •The same label can behave differently across CLOs, ABS, and private credit vehicles because definitions, thresholds, cure rights, and measurement dates are indenture-specific.
- •A trigger or trading process can be protective for senior debt while reducing liquidity, optionality, or residual value for junior investors.
- •Headline collateral performance is not enough; investors need the waterfall, tests, servicer or manager discretion, reporting package, and market liquidity context.
Technical details
Prepayment speed measurement (CPR)
Constant Prepayment Rate (CPR) measures annual prepayment speed. CPR = (Unscheduled Principal Payments ÷ Beginning Mortgage Balance) × 12. Example: $100M mortgage pool. Scheduled principal $500K/month. Actual principal $1.5M/month. Unscheduled = $1M/month. CPR = ($1M × 12) / $100M = 12% annual. Industry also uses PSA (Public Securities Association) curve—100 PSA assumes CPR ramps from 0% to 6% over 30 months, then stays at 6%. 200 PSA = 2× that speed (12% CPR at maturity). Typical agency MBS runs 10-30% CPR depending on rates and seasoning.
Prepayment drivers and behavior
Four main prepayment drivers: (1) Refinancing—borrowers refinance when rates drop 50-100bps below their coupon (the 'refi incentive'). (2) Turnover—home sales force payoffs regardless of rates (baseline ~5-7% CPR from turnover). (3) Curtailments—extra principal payments from borrowers (small impact, ~1-2% CPR). (4) Defaults—foreclosures/short sales force payoffs (higher during stress). Prepayment speeds are asymmetric: rise rapidly when rates fall (20-40% CPR in refi wave) but stay elevated baseline even when rates rise (turnover continues). This creates the negative convexity problem.
Prepayment protection in structured credit
Different structures provide varying prepayment protection. Pass-through MBS: No protection, investors bear full prepayment risk. CMO/REMIC PAC bonds: Planned Amortization Class bonds receive scheduled principal within 'collar' of prepayment speeds (90-300 PSA). Companion bonds absorb excess prepayments. Sequential pay CMOs: Principal pays tranches sequentially, creating maturity tranches less affected by prepayments. Lockouts: Many CMBS and non-QM loans have 2-5 year prepayment lockouts. Yield maintenance/defeasance: CMBS borrowers pay penalties equal to present value of lost interest. Auto ABS/Leases: Minimal prepayment risk from refinancing (loans too small, borrowers less rate-sensitive).
Document mechanics and defined terms
Analyze prepayment risk from the indenture, servicing agreement, collateral management agreement, offering memorandum, and trustee reports. Definitions control. The same phrase may have different calculation inputs, cure periods, exclusions, or consequences across deals.
Record the measurement date, responsible party, data source, threshold, test frequency, notice process, and remedy. If a term affects cash flow, identify which account, tranche, class, or party receives cash before and after the event.
For CLOs and ABS, connect the mechanic to adjacent tests such as OC, IC, WARF, CCC buckets, excess spread, delinquency, charge-off, concentration limits, and eligible collateral criteria.
Cash-flow and trading impact
Translate the mechanic into a cash-flow scenario. Does it redirect interest, trap excess spread, force principal paydown, limit reinvestment, change trading discretion, accelerate amortization, or alter who absorbs losses first?
Example: if a test breach diverts $5 million of quarterly excess spread from equity to senior note paydown, senior credit support can improve while equity's near-term distribution falls to zero. Both statements can be true.
Trading consequences matter as much as accounting consequences. A manager who loses reinvestment capacity or must satisfy a par, rating, or concentration constraint may sell assets earlier than fundamental credit analysis alone would suggest.
Market liquidity and price discovery
Structured credit marks are influenced by collateral fundamentals, tranche attachment, dealer balance-sheet capacity, BWIC flow, rating migration, financing availability, and the buyer base. Observable bids can gap even when loan-level defaults have not yet occurred.
Use multiple price references where possible: trustee marks, dealer runs, executed BWIC levels, independent pricing services, manager estimates, and comparable tranches. Stale marks deserve haircuts when the market is stressed or positions are idiosyncratic.
Liquidity stress can create feedback loops. Forced sales widen bid-ask spreads; wider spreads reduce marks and borrowing capacity; lower borrowing capacity can create more forced sales.
Monitoring dashboard and red flags
A practical dashboard should include collateral balance, par build or loss, OC and IC cushions, CCC exposure, WARF, diversity, defaulted assets, deferments, recoveries, reinvestment status, principal proceeds, interest proceeds, and recent trades or BWIC activity.
Red flags include shrinking test cushions, rising CCC buckets, repeated discretionary sales near reporting dates, unexplained cash traps, low payment rates, widening marks versus peers, servicer reporting delays, and concentration increases hidden by aggregate metrics.
For junior or residual investors, focus on path dependency. Two portfolios with the same ending default rate can produce different outcomes depending on when losses occur, whether reinvestment is allowed, and whether cash is diverted before equity receives distributions.