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.
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).