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Types of Bonds

A Different Sort of Bond: Prepayment Rates and Average Lives

Although CMOs entitle investors to payments of principal and interest, they differ from corporate bonds and Treasury securities in significant ways. Corporate and Treasury bonds are issued with stated maturities. The purchase of a bond from an issuer is essentially a loan to the issuer in the amount of the principal, or face amount, of the bond for a prescribed period of time in return for a specified annual rate of interest. The bondholder receives interest, generally in semiannual payments, until the bond is redeemed. When the bond matures or is called by the issuer, the issuer returns the “face value” of the bond to the investor in a single principal payment.

With a CMO, the ultimate borrower is the homeowner who takes on a mortgage loan. Because the homeowner’s monthly payments include both interest and principal, the mortgage security investor’s principal is returned over the life of the security, or “amortized,” rather than repaid in a single lump sum at maturity. CMOs provide monthly or quarterly payments to investors which include varying amounts of both principal and interest. As the principal is repaid or prepaid, interest payments become smaller, because they are based on a lower amount of outstanding principal.

A mortgage security “matures” when the investor receives the final principal payment. Most CMO tranches have a stated maturity based on the last date on which the principal from the collateral could be paid in full. This date is theoretical, because it assumes no prepayments on the underlying mortgage loans.

Mortgage securities are more often discussed in terms of their “average life” rather than their stated maturity date. Technically, the average life is defined as the average time to receipt of each dollar of principal, weighted by the amount of each principal payment. In simpler terms, the average life is the average time that each principal dollar in the pool is expected to be outstanding, based on certain assumptions about prepayment speeds. If prepayment speeds are faster than expected, the average life of the CMO will be shorter than the original estimate; if prepayment speeds are slower, the CMO’s average life will be extended. While some CMO tranches are specifically designed to minimize the effects of variable prepayment rates, the average life of the security is always a best estimate, contingent on how closely the actual prepayment speeds of the underlying mortgage loans match the assumptions.

 

All information and opinions contained in this publication were produced by the Securities Industry and Financial Markets Association from our membership and other sources believed by the Association to be accurate and reliable. By providing this general information, the Securities Industry and Financial Markets Association makes neither a recommendation as to the appropriateness of investing in fixed-income securities nor is it providing any specific investment advice for any particular investor. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and sources may be required to make informed investment decisions.