What Is Average Life?

The concept of average life pertains to the duration over which the principal amount of a debt instrument is anticipated to remain outstanding. It primarily considers the repayment of the principal, excluding interest payments, in various financial instruments like loans, mortgages, and bonds. In these contexts, average life signifies the average timeframe before the debt is fully repaid through either amortization or sinking fund payments.

Investors and analysts utilize the average life calculation to assess the risk inherent in amortizing bonds, loans, and mortgage-backed securities. This calculation aids in gauging the pace at which returns can be expected, facilitating the comparison of investment options. Typically, investors lean towards investments with shorter average life to accelerate returns on their finances.

Key Takeaways:

• The average life denotes the typical period required to repay the principal sum of a debt instrument like Treasury bills, bonds, loans, or mortgage-backed securities.
• Investors leverage the average life calculation to evaluate investment risks effectively before committing their resources.
• Opting for investments with a shorter average life enables investors to access returns swiftly.
• Prepayment risk emerges if a borrower or issuer repays the principal ahead of schedule, diminishing the investment’s average life and interest income.

Understanding Average Life

Referred to as both weighted average maturity and weighted average life, average life is computed to determine the time needed for the full repayment of a debt instrument, such as Treasury bills or bonds. While certain bonds repay the principal in one go at maturity, others do so through installments across the bond’s term. In cases of amortized bond principals, the average life aids investors in forecasting the repayment timeline.

Payment receipts are contingent on the repayment schedules of the loans supporting specific securities, like mortgage-backed securities (MBS) and asset-backed securities (ABS). As borrowers fulfil obligations, investors receive payments reflecting a proportion of cumulative interests and principals.

Calculating the Average Life on a Bond

To determine average life, multiply each payment date (expressed as a fraction of years or months) by the percentage of total principal repaid by that date, add these results, and divide by the total issue size.

For instance, consider a four-year annual-paying bond with a $200 face value and principal payments of $80 in the first year, $60 in the second, $40 in the third, and $20 in the final year. The average life is computed as follows:

($80 x 1) + ($60 x 2) + ($40 x 3) + ($20 x 4) = 400

Dividing the weighted total by the bond face value reveals the average life, which in this case is 2 years (400 divided by 200 = 2).

Thus, this bond’s average life is two years against its four-year maturity.

Mortgage-Backed and Asset-Backed Securities

In scenarios involving Mortgage-Backed Securities (MBS) or Asset-Backed Securities (ABS), the average life indicates the average duration for borrowers to repay the underlying debt. Investing in MBS or ABS entails acquiring a fractional interest in the related debt within the security.

The risk linked to MBS or ABS revolves around potential borrower defaults. Failures in payment result in losses for the security’s investors. Notably, the financial crisis of 2008 saw numerous defaults on home loans, particularly in the subprime sector, causing substantial losses in the MBS sphere.

Special Considerations

Apart from default risk, bond investors must also contend with prepayment risk. This risk emerges when bond issuers or borrowers under mortgage-backed securities repay the principal ahead of schedule, thereby shortening the investment’s average life and reducing interest income.

The unexpected reduction in interest poses a challenge for fixed-income security investors reliant on a consistent income stream, prompting some bonds to incorporate prepayment penalties to mitigate risks.