Prepayment Risk
The risk that a borrower repays a loan earlier than expected, forcing investors to reinvest at lower prevailing interest rates.
What is Prepayment Risk?
Prepayment risk is the risk that the borrower on a loan will repay all or part of the outstanding principal earlier than scheduled, particularly when interest rates fall and homeowners refinance. For investors in mortgage-backed securities (MBS) or other amortizing bonds, prepayment means receiving principal back sooner than expected and having to reinvest it at the current, lower interest rates — reducing the total return below what was projected. The opposite of prepayment risk is extension risk: when rates rise, prepayments slow and investors are stuck holding lower-yielding bonds for longer than anticipated. Both risks are forms of reinvestment risk inherent in callable or amortizing fixed-income securities.
Example
An investor buys a 30-year MBS yielding 5% when market rates are 5.5%. Rates drop to 3.5% and homeowners refinance en masse. The investor receives principal back rapidly and must reinvest at 3.5% — 150 basis points below the original yield. The MBS's actual duration shortens dramatically from 7 years to 2 years, a phenomenon called negative convexity.
Source: Investopedia — Prepayment Risk