Investment Decisions
It is important for decision-makers to understand the impact assumptions can have on the risk-return trade-offs presented in investment proposals. One of the key assumptions that can have a material impact on the decision information being presented is prepayment speeds.
Our focus in this blog is on investments with high yields and high premiums.
If the credit union pays more than the current face value for the investment, the additional payment is treated as an expense recognized over the life of the investment. Of course, the life of the investment is not only influenced by contractual maturities but also by prepayments.
The upside of the type of investment is if prepayments are slow, the higher coupon can help generate additional revenue. On the other hand, if prepayment speeds are faster than assumed, the investment will pay down faster than assumed—decreasing the investment yield by shortening the time the credit union has to recognize that premium.
In some instances, this may even create a situation in which the credit union has a negative yield, which is the result of earning less interest income over the life of the investment than what the credit union paid in premium.
When evaluating investments with high yields and high premiums, be sure to ask your investment advisor to explain the rationale of the prepayment assumptions being used and always insist on a stress test of the prepayment speeds, especially in the current rate environment. Prepayment assumptions used for the current rate environment typically include average CPRs over the last 1-, 3- or 12-months which can be a fair starting point, but the analysis should not stop there.
It is also prudent to gain a better understanding of the underlying collateral. For example, is the underlying collateral a pool of interest-only loans that are on the cusp of converting to principal and interest? How might borrower behavior change when principal and interest payments are due? Is it a pool of newly issued mortgages? As these mortgages become more seasoned, how might prepayments change? These are just a couple of examples of how prepayments in the future may be materially different than history.
