What Is Prepayment Risk?
Prepayment risk is the possibility that a bond owner will receive his or her principal investment back from the issuer prior to the bond’s maturity date. This can happen when interest rates fall and an existing bond is yielding above-market rates. Borrowers will often issue bonds or obtain loans at the new lower interest rates and use the proceeds to prepay other debt with higher interest rates. For example, firms generally issue bonds when interest rates decline in order to have funds available to pay off callable bonds at their next call date. A callable bond allows the issuer to retain the right to redeem the bond before its stated maturity date. A noncallable bond does not have this buyback privilege. As a consequence of the prepayment, the bondholder will not receive any more above-market interest payments from the investment. Prepayment also forces investors to reinvest their funds in a market where prevailing interest rates are lower than the rates paid by the prepaid bond. Neve
Prepayment risk is the amount of potential that exists for an investor or lender to not receive the projected return from the transaction. Risk of this type is associated with any type of lending situation where interest is assessed on the balance, or where investors purchase bonds in anticipation of recovering the face value plus some type of interest from the venture. Lenders and investors routinely consider the level of this type of risk before initiating any type financial transaction. Lenders usually are aware of consumer trends as they apply to the type of loans offered. Along with common trends, lenders may also look at the credit history of applicants to determine if they are a good risk in general and if they have a reputation for paying debts on time. Between the general averages related to the industry and the specific payment history of the loan applicant, it is possible to develop a reasonable idea of the prepayment risk involved with issuing the loan. Mortgage prepayment
