Definition
Prepayment risk is particularly relevant for mortgage-backed securities where homeowners can refinance when rates fall. Early principal return forces investors to reinvest at lower rates. When rates rise, prepayments slow, extending the investment's duration. This creates negative convexity for many MBS.
Example
When mortgage rates drop from 6% to 4%, many homeowners refinance, prepaying their mortgages and returning MBS principal early.
FAQ
What is Prepayment Risk?
The risk that borrowers will repay loans early, returning principal sooner than expected.
Why is Prepayment Risk important?
Prepayment Risk helps investors evaluate fixed income and make more informed decisions.