Introduction

The Weighted Average Coupon (WAC) refers to the average interest rate paid by the borrowers on the underlying mortgage loans that are bundled together to form a mortgage-backed security (MBS). It is calculated by taking into account both the individual interest rates of the loans and their respective principal amounts. The WAC gives investors a quick view of the overall return potential of the pool of loans supporting the security.

This concept is particularly relevant in structured finance products like MBS, asset-backed securities (ABS), and collateralized mortgage obligations (CMOs), which are increasingly being used in India by housing finance companies and NBFCs to raise funds from capital markets.

What Is the Weighted Average Coupon (WAC)?

In a pool of mortgage loans, each loan may carry a different interest rate. The WAC represents the average of these interest rates, weighted by the size of each loan's principal. It is a key metric used to understand the expected interest income from the entire loan pool backing the security.

The WAC helps investors and analysts assess:

• The income-generating potential of the bond.
• The bond’s sensitivity to prepayments and interest rate changes.
• The risk profile of the mortgage pool.

Why Is WAC Important?

• Investor Return Estimation: It gives a sense of the aggregate yield an investor might receive, before servicing fees or prepayment impacts.
• Valuation and Pricing: WAC plays a role in pricing the MBS and calculating yield to maturity or yield to worst.
• Prepayment Sensitivity: Higher WACs may indicate a higher chance of prepayments, especially when market rates fall.
• Comparison Tool: Helps compare one MBS or loan pool with another on a like-for-like interest basis.

How WAC Is Used in the Indian Market

In India, mortgage-backed securities (MBS) issued by housing finance companies and NBFCs often consist of hundreds or thousands of individual home loans. These loans might differ in terms of:

• Loan size
• Interest rate
• Repayment tenure

For investors such as mutual funds, insurance companies, and pension funds, the WAC gives an easy snapshot of the average interest income expected from the security, subject to prepayment behaviour and credit risk.

Factors That Affect WAC

• Interest Rate Distribution: If more loans in the pool carry higher interest rates, the WAC will be higher.
• Loan Size Distribution: Larger loans have a bigger impact on WAC due to higher weighting.
• Prepayments: Early repayments of high-interest loans will lower the WAC over time.
• Credit Profile of Borrowers: Riskier borrowers may be charged higher interest rates, influencing the WAC.

Conclusion

The Weighted Average Coupon (WAC) is a critical measure that reflects the blended interest rate on a pool of mortgage loans securing a bond or structured finance product. By weighting each loan’s interest rate against its principal, WAC helps investors understand the earning potential and interest rate exposure of a mortgage-backed investment.

For Indian investors looking into MBS or securitized loan portfolios, WAC offers a reliable benchmark to evaluate returns, compare securities, and make informed investment decisions in a market that is gradually expanding with innovative debt instruments.