Wall Street Words word of the day = Prepayment Risk

Hello YouTube, Todd Ault here, and Welcome to Wall Street Words! Today's Wall Street term is "Prepayment Risk"

Why would there be any risk to getting paid early? Let's say you're an insurance company and you buy a bond and that bond has quarterly interest payments and you need that money to take care of your policyholders. Well, if you buy a bond that can be paid off early and the rates go lower, you are in (or have) Prepayment Risk, meaning that someone can pay off that bond early and then, you as an insurance company, do not get those payments. This happens in MBS or mortgage backed securities and all kinds of corporate and municipal bonds. Prepayment Risk is for someone that's worried that they won't get income from bonds that could potentially be refinanced or paid off early. Today's word is "Prepayment Risk." Now, as a side note, there's a lot of complications of Prepayment Risk and their specific terminals, like a Bloomberg terminal, which you can put a bond in and look at its maturity dates and when it can be paid off. Very complicated, but in simplistic terms, Prepayment Risk is the risk that your bond you own is going to pay you early. "Prepayment Risk" is the word today.

Definition - The risk involved with the premature return of principal on a fixed-income security. When debtors return part of the principal early, they do not have to make interest payments on that part of the principal. That means investors in associated fixed-income securities will not receive interest paid on the principal. The prepayment risk is highest for fixed-income securities, such as callable bonds and mortgage-backed securities (MBS). Bonds with prepayment risk often have prepayment penalties. The core problem with prepayment risk is that it can stack the deck against investors.

Not all bonds have prepayment risk. If a bond cannot be called, then it does not have prepayment risk. A bond is a debt investment in which an entity borrows money from an investor. The entity makes regular interest payments to the investor throughout the bond's maturity period. At the end of the period, it returns the investor's principal. Bonds can either be callable or noncallable. For a callable bond, the higher a bond's interest rate relative to current interest rates, the higher the prepayment risk. With mortgage-backed securities, the probability that the underlying mortgages will be refinanced increases as current market interest rates fall further below the old rates. For example, a homeowner who takes out a mortgage at 7% has a much stronger incentive to refinance after rates drop to 4% or 5%. When and if the homeowner refinances, those who invested in the original mortgage on the secondary market do not receive the full term of interest payments. If they wish to keep investing in the mortgage market, they will have to accept lower interest rates or higher default risk.

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