Prepayment Speed

Prepayment Speed is a measure of how quickly borrowers are paying off their debts ahead of the scheduled payment plan. Think of it as the churn rate for loans. While this can apply to various types of debt, it's a superstar concept in the world of mortgage-backed securities (MBS) and other asset-backed securities (ABS). When you buy an MBS, you're essentially buying a stream of income from thousands of underlying mortgage payments. Prepayment speed tells you how fast the homeowners in that pool are paying off their mortgages, either by refinancing or selling their homes. This rate is a critical, and often unpredictable, variable that can dramatically impact an investor's return. It's not just an academic footnote; it’s a core risk that can either supercharge your returns or sink them, depending on the price you paid for the security.

Imagine you're a landlord, and you've just rented your property to a fantastic tenant on a long-term lease at a great rate. Suddenly, the tenant decides to move out and pays off the entire lease. You get your money back, which sounds good, but now you have to find a new tenant. If rental rates in your area have plummeted, you're stuck reinvesting your capital (the property) for a lower return. This is precisely the dilemma for an MBS investor. The speed of prepayments creates two major, opposing risks:

• Reinvestment Risk: This is the big one. When interest rates fall, homeowners rush to refinance their mortgages at the new, lower rates. This causes a flood of prepayments. For the MBS investor, this means you get your principal back much faster than you expected. Now you have a pile of cash to reinvest, but you have to do it in the same low-rate environment that caused the prepayments in the first place. You're forced to replace a high-yielding asset with a low-yielding one, which crushes your overall yield.
• Extension Risk: This is the opposite problem. When interest rates rise, homeowners stay put. Why would they refinance a 3% mortgage for a new 7% one? Prepayments slow to a crawl. If you bought the MBS expecting a certain rate of principal return, you're now stuck holding a lower-yielding investment for much longer than anticipated, while newer, more attractive bonds are being issued at higher rates. Your capital is essentially trapped in an underperforming asset.

Prepayment behavior is notoriously tricky to predict because it's driven by human decisions. However, the key drivers are well-understood.

This is the most powerful driver. The difference between a homeowner's current mortgage rate and prevailing market rates is the primary incentive to refinance. A significant drop in market rates can trigger a refinancing wave, causing prepayment speeds to accelerate dramatically.

A strong economy and a hot housing market are a recipe for high prepayments. When people feel confident, they are more likely to sell their homes and move—a transaction that forces the mortgage to be paid off in full. High home price appreciation also builds home equity, making it easier for homeowners to qualify for refinancing. Conversely, a recession tends to slow everything down.

Not all loans are created equal. Several factors specific to the loans themselves influence prepayment speed:

• Seasoning: This refers to the age of the mortgage. Prepayments are typically slow in the first couple of years (as people are less likely to move right after buying) but tend to speed up as the loan “seasons.”
• Loan-to-Value (LTV): A lower LTV ratio (meaning the homeowner has more equity) makes it easier to refinance, increasing the likelihood of prepayment.
• Location: Prepayment speeds can vary significantly by geographic region due to differences in local economic health and housing market mobility.

To tame this uncertainty, analysts use standardized models to measure and forecast prepayment speeds.

Two fundamental metrics are used to express prepayment speed:

• Single Monthly Mortality (SMM): This measures the percentage of the remaining mortgage principal that is prepaid in a single month. It’s the raw, monthly number.
• Conditional Prepayment Rate (CPR): This is the more commonly cited figure. It’s simply the SMM annualized. It represents the percentage of principal that would be prepaid over a year, assuming the SMM remains constant. A 6% CPR means that, at the current rate, 6% of the outstanding principal in the mortgage pool will be paid off over the next year.

To create a common language for comparing prepayment speeds, the industry uses the Public Securities Association (PSA) prepayment model (now managed by SIFMA). The PSA model isn't a forecast; it's a benchmark.

• 100 PSA represents a baseline speed, assuming a CPR that starts at 0.2% in the first month and increases by 0.2% each month for 30 months, where it levels off at a constant 6% CPR for the remaining life of the loan.
• Other speeds are expressed as a multiple of this baseline. A security prepaying at 200 PSA is experiencing twice the benchmark speed, while 50 PSA is half the speed. This allows investors to quickly gauge if a security's prepayments are fast or slow relative to a market standard.

For a value investing practitioner, prepayment risk is not just a danger to be avoided but an opportunity to be exploited. The key lies in the price you pay for the bond.

• Bonds Bought at a Premium: If you pay more than the bond's face value (e.g., $105 for a $100 bond), you are betting on slow prepayments. Fast prepayments are your enemy. Every early principal payment you receive means a portion of the premium you paid is lost forever. A smart investor must be confident that the bond's attractive yield is high enough to compensate for the risk of rapid prepayments.
• Bonds Bought at a Discount: If you buy a bond for less than its face value (e.g., $95 for a $100 bond), fast prepayments are your best friend. Every early principal payment not only returns your capital but also accelerates your gain (you get back $100 for an asset you paid $95 for). Here, the value investor looks for situations where the market is overly pessimistic about prepayment speeds, offering a chance to buy cheap and profit as homeowners refinance or move.

Ultimately, understanding prepayment speed is about looking beyond the stated yield of an MBS and forming an independent judgment about the future behavior of the underlying borrowers. It's a classic value investing scenario: find a security where the market's assumptions are flawed and a more probable reality offers an attractive return.