What Is Yield-to-Average Life?
Let me explain yield-to-average life directly to you: it's a way to calculate a bond's yield using the average maturity instead of the stated maturity date. This approach replaces the final maturity with the average life maturity, which is also known as weighted average maturity (WAM) or weighted average life (WAL).
Key Takeaways
You should know that yield-to-average life calculates the yield based on average maturity, not the stated date. It figures out how long it takes to recover half of the bond’s face value. Trustees for sinking fund bonds use this to decide if they should buy back bonds on the open market.
Understanding Yield-to-Average Life
I want you to understand that yield-to-average life helps you estimate the real return from a bond, no matter the exact maturity date. The calculation assumes the bond matures on its average life date at the average redemption price, not the par price. You can compute it using the yield to maturity (YTM) formula, just swap in the average life for maturity.
This metric tells you the time to recover half the bond’s face value. If principal repays faster, it reduces default risk and lets you reinvest sooner. Whether that's good or bad depends on interest rate changes since you bought the bond.
Some bonds pay principal in a lump sum at maturity, but others do it in installments via a sinking fund. The issuer sets aside money regularly into a separate account just for redeeming bonds. This amortization means the average life calculation shows you how soon principal repayment happens.
For sinking fund bonds, trustees use yield-to-average life to see if they should repurchase bonds on the open market, especially if they're trading below par. Here, the average life could be much shorter than the years to actual maturity.
A sinking fund repays borrowed funds through periodic payments to a trustee who buys back bonds openly. This boosts the corporation's creditworthiness, allowing lower interest rates to investors.
Yield-to-Average Life for Mortgage-Backed Securities
Now, consider mortgage-backed securities (MBS): yield-to-average life lets you determine expected returns due to prepayments on underlying mortgages. It's key for pricing MBS like collateralized mortgage obligations (CMOs) from Freddie Mac or private issuers.
MBS typically repay principal over the investment's life. If bought at a discount or premium, early principal payments affect your expected return.
In falling interest rate environments, homeowners often refinance, paying off old loans with new ones at lower rates.
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