What Is Average Life?
The average life is the length of time the principal of a debt issue is expected to be outstanding. Average life does not take into account interest payments, but only principal payments made on the loan or security. In loans, mortgages, and bonds, the average life is the average period of time before the debt is repaid through amortization or sinking fund payments.
Investors and analysts use the average life calculation to measure the risk associated with amortizing bonds, loans, and mortgage-backed securities. The calculation gives investors an idea of how quickly they can expect returns and provides a useful metric for comparing investment options. In general, most investors will choose to receive their financial returns earlier and will, therefore, choose the investment with the shorter average life.
Key Takeaways
- The average life is the average length of time it will take to repay the outstanding principal on a debt issue, such as a Treasury bill, bond, loan, or mortgage-backed security.
- The average life calculation is useful for investors who want to compare the risk associated with various investments before making an investment decision.
- Most investors will choose an investment with a shorter average life as this means they will receive their investment returns sooner.
- Prepayment risk occurs when the loan borrower or bond issuer repays the principal earlier than scheduled, thereby shortening the investment's average life and reducing the amount of interest the investor will receive.
Understanding Average Life
Also called the weighted average maturity and weighted average life, the average life is calculated to determine how long it will take to pay the outstanding principal of a debt issue, such as a Treasury Bill (T-Bill) or bond. While some bonds repay the principal in a lump sum at maturity, others repay the principal in installments over the term of the bond. In cases where the bond's principal is amortized, the average life allows investors to determine how quickly the principal will be repaid.
The payments received are based on the repayment schedule of the loans backing the particular security, such as with mortgage-backed securities (MBS) and asset-backed securities (ABS). As borrowers make payments on the associated debt obligations, investors are issued payments reflecting a portion of these cumulative interest and principal payments.
Calculating the Average Life on a Bond
To calculate the average life, multiply the date of each payment (expressed as a fraction of years or months) by the percentage of total principal that has been paid by that date, add the results, and divide by the total issue size.
For example, assume an annual-paying four-year bond has a face value of $200 and principal payments of $80 during the first year, $60 for the second year, $40 during the third year, and $20 for the fourth (and final) year. The average life for this bond would be calculated with the following formula:
($80 x 1) + ($60 x 2) + ($40 x 3) + ($20 x 4) = 400
Then divide the weighted total by the bond face value to get the average life. In this example, the average life equals 2 years (400 divided by 200 = 2).
This bond would have an average life of two years against its maturity of four years.
Mortgage-Backed and Asset-Backed Securities
In the case of an MBS or ABS, the average life represents the average length of time required for the associated borrowers to repay the loan debt. An investment in an MBS or ABS involves purchasing a small portion of the associated debt that is packaged within the security.
The risk associated with an MBS or ABS centers on whether the borrower associated with the loan will default. If the borrower fails to make a payment, the investors associated with the security will experience losses. In the financial crisis of 2008, a large number of defaults on home loans, particularly in the subprime market, led to significant losses in the MBS arena.
Special Considerations
While certainly not as dire as default risk, another risk bond investors face is prepayment risk. This occurs when the bond issuer (or the borrower in the case of mortgage-backed securities) pays back the principal earlier than scheduled. These prepayments will reduce the average life of the investment. Because the principal is paid back early, the investor will not receive future interest payments on that part of the principal.
This interest reduction can represent an unexpected challenge for investors of fixed-income securities dependent on a reliable stream of income. For this reason, some bonds with payment risk include prepayment penalties.
Certainly! The concept of "average life" within finance refers to the anticipated duration that the principal of a debt instrument is expected to remain outstanding. This term doesn't account for interest payments but instead focuses solely on the principal repayments made on a loan or security. It's commonly used in analyzing the risk associated with amortizing bonds, loans, and mortgage-backed securities.
The calculation involves determining the average period before the debt is repaid through amortization or sinking fund payments. Investors use this metric to gauge the speed at which they can anticipate returns and compare different investment options. Typically, investors lean towards investments with shorter average lives, as it implies receiving returns sooner.
Prepayment risk is a significant concern, especially with bonds or securities subject to early principal repayment. This risk can shorten the investment's average life, leading to reduced interest for investors. This was notably evident during the 2008 financial crisis, where defaults on home loans, particularly in the subprime market, led to substantial losses in mortgage-backed securities.
To calculate the average life, one must consider the date and amount of each payment made towards the principal. For instance, with a bond having different principal payments over a four-year term, you'd multiply each payment by the corresponding year, sum the results, and divide by the total issue size. The outcome indicates the average life against the maturity period.
In mortgage-backed securities (MBS) and asset-backed securities (ABS), the average life reflects the duration required for associated borrowers to repay the loan debt. Investing in MBS or ABS entails buying a portion of the bundled debt within the security, where risks revolve around borrower defaults.
Additionally, prepayment risk in bonds or mortgage-backed securities can disrupt expected returns by shortening the average life of the investment. This early repayment diminishes future interest payments, posing an unexpected challenge for fixed-income securities reliant on a consistent income stream.
Understanding these elements, such as the calculation methods and the implications of prepayment risks, is crucial for investors to assess and mitigate potential financial vulnerabilities associated with different debt instruments.
