Call and Prepayment Risk

A bond may have a call provision that allow the issuer to call the bond back before its maturity date. Since a call feature is a benefit to the issuer, its value is lower than a similar plain vanilla bond. The call provision brings three key disadvantages to the investor.

1. The investor cannot be certain about the cash flow pattern of its investment, as he doesn’t know when the bond could be called back.
2. There is higher reinvestment risk. This is because the changes of a bond call back increases if interest rates decline, and the investor will have to reinvest the funds at a lower rate.
3. In a declining interest rate environment, the price appreciation of a callable bond is limited compared to an option-free bond. This phenomenon is also called price compression.

Put together all these form the call risk for the investors. Similar to call risk, there is prepayment risk in mortgage-backed securities. The mortgage-backed securities are backed by a pool of thousands of loans. The cash flow generated from this mortgage pool is used to pay the cash flow to the MBS investors. The borrowers of the loans underlying these MBS can prepay their loans in a falling interest rate environment, which will affect the cash flows of the securities.

In mortgage-backed securities, the investors, along with the scheduled amortized payments, also receive unscheduled payment arising due to prepayments from the borrowers. Due to these unscheduled payments, it becomes difficult to assess the exact cash flow and maturity of the MBS.