Average Life: Definition, Calculation Formula, and Maturity
The average life of a debt issuance refers to how long the principal is anticipated to remain unpaid. The average life only accounts for principal payments made on the loan or security; interest payments are not included. The average life of a loan, mortgage, or bond is before amortization or sinking fund payments are made to pay off the debt.
Analysts and investors use the average life calculation to evaluate the risk of amortizing bonds, loans, and mortgage-backed securities. The computation is a helpful indicator for evaluating investment possibilities and gives investors an indication of how soon they might anticipate profits. Most investors, on the whole, will opt for an investment with a shorter average life because they want to get their money back sooner.
Comprehending Typical Life
The average life, also known as the weighted average maturity or average life, is a financial tool used to estimate how long it will take to pay off the principal balance of a debt issue, like a bond or Treasury Bill (T-Bill). Certain bonds have a one-time principal repayment at maturity, while others have periodic principal repayments over the bond’s tenure. Investors can ascertain the principal repayment rate in situations where the bond’s principal is amortized by looking at the average life of the bond.
The loan repayment terms make payments for specific securities, such as asset-backed securities (ABS) and mortgage-backed securities (MBS). Investors get payments representing a percentage of the cumulative interest and principal payments made by borrowers when they fulfill their obligations under the related loan.
Finding the Typical Life of a Bond
Multiply each payment date (given as a fraction of years or months) by the portion of the principal paid by that date to determine the average life. Then, sum the findings and divide by the entire issue size.
For illustration purposes, assume that a $200 bond is an annual-paying bond with principal payments of $80 in the first year, $60 in the second, $40 in the third, and $20 in the fourth (and final) year. The following calculation might be used to determine this bond’s average life:
($20 x 4) + ($60 x 2) + ($40 x 3) = 400
To find the average life, divide the weighted total by the face value of the bond. In this case, the average life is two years (400 divided by 200 = 2).
Compared to its four-year maturity, this bond would have an average life of two years.
Securities Backed by Assets and Mortgages
An MBS or ABS’s average life denotes the typical period the related borrowers need to pay back the loan balance. Investing in an ABS or MBS entails buying a small percentage of the debt packaged with the security.
Whether the borrower linked to the loan defaults is the primary source of risk connected with an MBS or ABS, the investors connected to the security will suffer losses if the borrower defaults. Numerous home loan failures during the 2008 financial crisis, especially in the subprime sector, resulted in significant losses for MBS holders.
Particular Points to Remember
Prepayment risk is another danger bond investors confront, but one that is unquestionably not as serious as default risk. This happens when the bond issuer (or the borrower in the case of mortgage-backed securities) repays the principal ahead of schedule. These prepayments will shorten the investment’s average life. The investor will not get any interest payments on that principal portion in the future because it was paid back early.
For investors in fixed-income securities that depend on a steady income stream, this interest rate cut may create an unforeseen problem. Prepayment penalties are a feature of some bonds that carry a payment risk because of this.
Conclusion
- The typical life of a debt issue, such as a Treasury bill, bond, loan, or mortgage-backed instrument, is the average time to pay back the principal amount owed.
- When making an investment choice, investors who wish to evaluate the risk involved with different options can do so using the average life calculation.
- Since they will receive their investment returns sooner, most investors will select an investment with a shorter average life.
- Prepayment risk arises when a bond issuer or borrower makes principal repayments ahead of schedule, lowering the investor’s interest rate and shortening the investment’s average life.
