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Investment Decisions: Prepayment Assumptions Can Drive the Results

March 28, 2013

Yield tables provide a wealth of information to evaluate prospective investment purchases.  Take the example below.  The screen shows the coupon and the prices as well as possible prepayment speed, yield and average life depending on the rate environment.

Not unlike the IRR process, decision-makers should asses the reasonableness of the assumptions being presented in the table. The key assumption is the prepayment speed which affects the potential yield and average life of the investment.  Referring to the example, the assumed prepayment in the current rate environment is 460 PSA which causes the potential yield to be 0.825%.  You can observe that the prepayment speed over the life of this investment has been 610 PSA and has been increasing over the last 12 months (see historical prepayments box on the example).

Keep in mind the importance of the prepayment assumption when there are large premiums (as indicated by the 108-13 Price).  The calculated yield would be materially lower if any of the historic prepayment speeds were used.  For example, looking at the -100bp rate environment, the prepayment speed is 712 PSA which matches the 6-month experience of this investment.  The yield with the higher prepayment speed is now almost breakeven at 0.071% compared to the 0.825% with the 460 PSA.   The difference in yield is drastic and likely changes the decision a credit union would make.

The question is, why is a lower prepayment speed being used?  It could be an expectation that prepayments will slow in the future or it could be that the higher resulting yield makes the investment look more attractive.  Historical prepayment behavior may not be an accurate predictor of future prepayment behavior, so the prepayments could slow down.  However, using history is a reasonable starting point for understanding what the possible yield is.  From there, decision-makers should test a range of prepayment speeds in order to understand the yield impact and make sure they are comfortable with the possibilities.

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