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Lesson 1 of 5 · 11 min
Prepayment risk and time tranching
Borrowers can repay principal faster or slower than scheduled as interest rates move, and time tranching splits a pool into bonds with different expected maturities so investors can choose which side of that risk they bear.
In short
- Prepayment risk: the risk that principal comes back at a different pace from the contractual schedule. It has two sides, both driven by interest rates.
- Contraction risk: rates fall, borrowers refinance, principal arrives early. The investor reinvests at lower rates and the bond's price gain is limited.
- Extension risk: rates rise, refinancing dries up, principal arrives late. The investor's cash flows are stretched out and discounted at higher rates.
- Time tranching creates bond classes with different expected maturities, typically by paying principal sequentially: first to one tranche until it is retired, then to the next.
- Time tranching redistributes prepayment risk; credit tranching (subordination) redistributes default losses. One deal often uses both.
- Because of prepayments, the contractual maturity of an MBS says little; investors use the weighted average life (average life) instead.
Why scheduled and actual cash flows differ
A mortgage or other amortizing loan comes with a payment schedule, but borrowers do not always follow it. They may pay early, pay late or stop paying. What they do depends on their income, on the loan terms (such as the original rate versus today's rates and any prepayment penalty) and on whether they sell the asset being financed.
So the cash flows of an ABS or MBS pass-through are uncertain. To value these securities, investors start from the contractual payments and then layer on assumptions about how fast principal will actually come back.
Prepayment risk is the risk that borrowers repay principal, or part of it, at a different speed from the agreed schedule. It has two components, contraction risk and extension risk, and both are driven by changes in the general level of interest rates.
Contraction risk and extension risk
When rates fall, homeowners with fixed-rate mortgages refinance at the new lower rate. Prepayments run above forecast, so the MBS pays off sooner than expected when it was bought. Refinancing is especially common in the US because most mortgages there carry no prepayment penalty.
That is contraction risk, and it hurts twice. The investor gets principal back just when it can only be reinvested at lower rates. And the borrower's option to prepay caps how far the bond's price can rise as rates fall.
When rates rise, refinancing stops making sense and some people even delay buying a new home. Prepayments run below forecast, so the MBS lasts longer than expected. That is extension risk: the investor is stuck with below-market cash flows for longer, and every one of them is discounted at a higher rate.
| Contraction risk | Extension risk | |
|---|---|---|
| Trigger | Interest rates fall | Interest rates rise |
| Borrower behaviour | Refinances; prepays faster | Stops refinancing; prepays slower |
| Effect on MBS life | Shorter than expected | Longer than expected |
| Investor's problem | Reinvest at lower rates; limited price gain | Lower value of cash flows, stretched out at higher discount rates |
Either way the investor loses. The borrower holds the option to prepay and uses it when it suits the borrower, which is exactly when it does not suit the lender.
Time tranching
A securitization cannot make prepayment risk disappear, but its structure can share it out unevenly. The tool is time tranching: creating bond classes with different expected maturities from the same pool.
The usual design is sequential. All principal (scheduled and prepaid) goes to the first tranche until it is fully repaid; then principal flows to the second tranche until it is repaid, and so on. The short tranche gets its money first; the long tranches wait.
Investors can then pick a tranche to match when they need cash. But the maturities are only expected: if prepayments surge, every tranche is repaid earlier than planned; if they stall, every tranche runs longer.
Time tranching is different from credit tranching, where junior (subordinated) classes absorb default losses before senior ones. A single deal commonly has both: classes that rank one above another for losses and that also have staggered expected maturities.
| Credit tranching | Time tranching | |
|---|---|---|
| Redistributes | Credit (default) losses | Prepayment risk (timing of principal) |
| Mechanism | Subordination: junior classes absorb losses first | Different expected maturities, e.g. sequential principal payments |
Average life instead of maturity
An MBS repays principal every month through scheduled amortization and through unscheduled prepayments. So its stated (legal) maturity, say 30 years, tells you almost nothing about when you will actually get your money back.
Market participants therefore look at the weighted average life, or simply average life, of the MBS: how long the investor can expect to hold it before it is paid off, assuming rates stay where they are and the expected prepayments occur.
Because prepayments respond to rates, the average life is not fixed. Falling rates shorten it (contraction); rising rates lengthen it (extension). This is also why a 30-year MBS and a 30-year option-free corporate bond with the same coupon do not carry the same interest rate risk.
Worked examples
Example 1 Which risk, which consequence?
Hedda holds a pass-through backed by fixed-rate home loans. Scenario 1: mortgage rates drop 1.5 percentage points. Scenario 2: mortgage rates rise 2 percentage points. For each, what happens to prepayments and the expected life of the security, and what is her main problem?
Example 2 Sequential principal in action
A EUR 400 million pool backs three sequential tranches: A (EUR 200m), B (EUR 120m), C (EUR 80m). Over the first two years borrowers repay EUR 150 million of principal (scheduled plus prepaid). Then rates fall and in year 3 a further EUR 110 million comes in. What is each tranche's balance after year 3?
On the exam
Definitions of contraction versus extension risk and which rate move triggers each, which adverse consequence belongs to which risk, and the difference between time tranching (prepayment risk) and credit tranching (default risk).
- Swapping the consequences: reinvesting at lower rates and capped price appreciation belong to contraction risk, not extension risk.
- Thinking time tranching removes prepayment risk. It only redistributes it among the tranches.
- Calling a senior/subordinated structure time tranching. Subordination is credit tranching.
- Treating the legal maturity of an MBS as its expected life; use the average life.
Check yourself
Q1Mortgage rates fall sharply and the expected life of an MBS shortens. The investor is most likely experiencing:
Q2Which adverse consequence is most likely associated with extension risk?
Q3A structure that pays all principal to one bond class until it is retired, then to the next, is best described as:
Q4A foundation must fund a building project in three years and is most concerned about extension risk. In a sequential-pay structure it should most likely buy:
Q5Which statement about the maturity of an MBS is most accurate?
Answer the 5 questions: +10 XP for each one you get right first time.
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