Prepayment Risk

The risk that the principal on a fixed-income security is returned early.  Bonds may be “called” ahead of maturity if interest rates are signficantly lower than the current interest being paid on the bond. It would be more advantangeous for the firm to buy back the bonds and perhaps issue new bonds at lower rates.

Prepayment risk also exists in mortgages, which was a major difficulty at first to creating mortgage-backed securities. Eventually, the prepayment risk was assessed with historical data and the mortgages were divided into tranches. The lower tranches would receive their principal in case of early prepayment, while the upper tranches would only receive early principal payments after the lower tranches had been paid off.

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