prepayment risk

Aunty Bisi in Manchester had it all mapped out. She put part of her savings into a bond fund that held mortgage backed securities, the kind of investment that pools together thousands of home loans and pays investors a steady interest income from the repayments. She liked the predictability. Every quarter, a nice, calm payment landed, and she planned her remittances home around it.

Then interest rates fell sharply, and thousands of homeowners in that pool rushed to refinance their mortgages at cheaper rates. That meant they paid off their old loans early, in full. Good news for them, but for Aunty Bisi, it meant the fund suddenly had a pile of cash to reinvest, at the new, lower rates. Her income shrank just when she needed it most, because the fat interest payments she was counting on had dried up ahead of schedule.

That is prepayment risk in a nutshell. It is the risk that the borrowers whose loans back your investment pay those loans off sooner than expected, usually when rates drop and refinancing becomes attractive. The lender or the fund gets its money back early, but has to lend it out again at the new, less generous rate.

It shows up wherever a return depends on someone else's loan running its full course. A Nigerian pension fund holding mortgage backed bonds faces it. A UK investor in a fund of buy to let mortgages faces it too. Even informal savings arrangements can carry a cousin of this risk, if the person you lent to insists on repaying you early, leaving your money idle when you had other plans for that steady return.

The lesson is not to avoid such investments, but to know that a fixed sounding income is not always fixed in timing. Ask how the investment behaves if rates fall and everyone rushes to repay early.