Introduction

Prepayment Risk refers to the possibility that the borrower repays the principal of a fixed-income security before its scheduled maturity date. While early repayment may sound positive on the surface, it can be a disadvantage for investors—particularly those relying on long-term interest income. This is because when principal is paid back early, the issuer no longer pays interest on that portion, which reduces the total return an investor expects to earn.

In India, prepayment risk is particularly relevant in mortgage-backed securities (MBS), asset-backed securities (ABS), and callable bonds issued by corporates or financial institutions.

How Prepayment Risk Works

In fixed-income instruments, investors receive regular interest on the outstanding principal. If the issuer decides to repay a portion or all of the principal early—often due to falling interest rates or access to cheaper credit—then:

• The investor receives their money back sooner than expected.
• They stop earning interest on the prepaid portion.
• They may be forced to reinvest at lower interest rates, especially during a declining rate environment.
• Thus, the risk lies in losing future interest income and being unable to reinvest at comparable returns.

Where Is Prepayment Risk Most Common?

• Mortgage-Backed Securities (MBS): Home loan borrowers often prepay their loans, especially when refinancing or selling property.
• Callable Bonds: Issuers may "call" the bond and repay the principal before maturity to reduce borrowing costs.
• Structured Finance Instruments: Securitised instruments backed by personal loans, auto loans, or gold loans often face prepayment from borrowers.

Impact on Indian Investors

In India, NBFCs and housing finance companies often pool loans into pass-through certificates (PTCs) for securitisation. These loans may be repaid early due to:

• Prepayment by borrowers in case of surplus funds.
• Loan transfers (e.g., home loan balance transfers).
• Falling interest rates leading to refinancing.
• Investors in such securities—mainly mutual funds, insurance companies, and pension funds—may experience irregular cash flows and lower-than-expected returns due to prepayments.

Why Prepayment Happens

• Declining Interest Rates: Borrowers refinance to newer loans with lower rates.
• Increased Income: Borrowers may choose to repay early if their income or liquidity improves.
• Loan Transfers or Foreclosure: Home loans in India are often transferred to banks offering lower EMIs.
• Windfall Gains: Sale of property or inheritance may lead to early loan settlement.

Consequences of Prepayment Risk for Investors

• Loss of Expected Interest Income: The bond or loan stops generating returns on prepaid amounts.
• Reinvestment Risk: The returned capital may have to be reinvested at lower yields.
• Uncertainty in Cash Flow: Especially critical for funds or institutions that rely on fixed repayment timelines.
• Capital Reallocation Pressure: Investors may have to rework their portfolio if prepayments are significant.

Managing Prepayment Risk

Investors and institutions can use the following strategies:

• Choose Non-Callable Instruments: These do not allow issuers to repay before maturity.
• Stagger Investments: Laddering across different maturities helps reduce concentrated risk.
• Use Prepayment Penalties: Some bonds include penalties for early repayment to compensate investors.
• Diversify Across Assets: Combining fixed-income with equities or alternative assets can balance the risk.
• Model Cash Flows: Institutions use models to forecast prepayment behaviour and plan accordingly.

Prepayment Penalties in Bonds

• To mitigate investor losses, callable bonds or loan contracts often include prepayment penalties or call premiums. These are additional amounts paid by the issuer if they choose to repay early, helping offset the loss of interest income for the investor.
• In India, prepayment penalties were common in corporate bonds and housing loans but have been reduced or eliminated for individual borrowers in floating rate loans, following regulatory changes by RBI and NHB.

Conclusion

Prepayment Risk is an important but often overlooked aspect of fixed-income investing. While it may seem like a borrower-friendly feature, it can disrupt expected returns, impact cash flow predictability, and force investors to reinvest at lower yields. For investors, especially those involved in MBS, ABS, and callable corporate bonds, understanding prepayment risk is crucial for effective portfolio management and realistic return expectations. By planning for this possibility and choosing suitable instruments, investors can minimise disruptions and maintain stability in their fixed-income investments.