What Is Average Life?
Let me explain what average life means in the context of debt instruments. It's the expected length of time that the principal of a debt issue will remain outstanding. Remember, this focuses only on principal payments, not interest. For loans, mortgages, and bonds, it's the average period before the debt is repaid via amortization or sinking fund payments.
As an investor or analyst, you'll use this calculation to gauge the risk in amortizing bonds, loans, and mortgage-backed securities. It tells you how quickly you can expect your returns and helps in comparing different investments. Generally, you'll prefer investments with shorter average lives because that means getting your money back sooner.
Key Takeaways
- The average life is the average time to repay the outstanding principal on debts like Treasury bills, bonds, loans, or mortgage-backed securities.
- This calculation helps you compare risks across investments before deciding.
- You'll likely choose shorter average life investments to receive returns faster.
- Prepayment risk happens when principals are repaid early, shortening the average life and cutting your interest earnings.
Understanding Average Life
You might also hear it called weighted average maturity or weighted average life. I calculate it to figure out how long it takes to pay off the outstanding principal of something like a Treasury Bill or bond. Some bonds pay the principal all at once at maturity, but others do it in installments over time. When the principal is amortized, average life shows you how fast it'll be repaid.
Payments depend on the repayment schedule of the underlying loans, especially in mortgage-backed securities (MBS) and asset-backed securities (ABS). As borrowers pay their debts, you as an investor get portions of those cumulative interest and principal payments.
Calculating the Average Life on a Bond
To calculate average life, you multiply each payment date (as a fraction of years or months) by the percentage of total principal paid by then, sum those up, and divide by the total issue size.
Take this example: an annual-paying four-year bond with a $200 face value, paying $80 in year one, $60 in year two, $40 in year three, and $20 in year four. The formula is ($80 x 1) + ($60 x 2) + ($40 x 3) + ($20 x 4) = 400. Divide 400 by 200, and you get an average life of 2 years. So, this bond has a 2-year average life despite maturing in 4 years.
Mortgage-Backed and Asset-Backed Securities
For MBS or ABS, average life is the average time for borrowers to repay their loans. When you invest in these, you're buying a slice of the packaged debt.
The main risk here is default—if the borrower doesn't pay, you lose out. The 2008 financial crisis showed this clearly, with massive defaults in subprime home loans causing huge losses in MBS.
Special Considerations
Beyond default, there's prepayment risk. This is when the issuer or borrower pays back principal earlier than planned, shortening the average life. You miss out on future interest from that principal.
This can disrupt your expected income stream if you're relying on fixed-income securities. That's why some bonds include prepayment penalties to mitigate this.
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