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.
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