Average life is the length of time that each unit of unpaid principal is expected to remain outstanding. The average life of mortgages, bonds, and loans refers to the estimated time to pay principal through amortization or sinking funds.
Some issued assets such as bonds include purchase funds that enable the repurchasing of stock within particular price ranges. Purchase funds are optional; hence, they do not affect the investors’ long-term returns, so they are ignored when calculating the average life on bonds.
Average life is the average duration that it can take a borrower to repay the unpaid principal amount on a loan.
Financial analysts and investors use average life to determine how fast an investment will realize returns.
Different methodologies are used to calculate average life, depending on a market segment.
Understanding Average Life
Average life is also known as weighted average life. Analysts use the metric to determine the time it takes to repay the outstanding principal amount of a loan. Debt issues, such as bonds, require borrowers to pay the principal either in a lump sum at maturity or in installments over the term period.
Investors can, therefore, use the average life to determine how quickly the principal will be paid in cases of amortized principal. The received payments are based on assumed prepayment speed and a schedule that provides liquidity to a particular security, such as assets or mortgage-backed securities.
Investors get dividends that reflect portions of cumulative payments made by borrowers on the respective debt obligations.
Uses of Average Life
Average life is used to measure the risks associated with loans and amortization bonds. The calculation provides an important metric for determining how the market value of each asset and liability changes with the changing interest rates.
Analysts and investors can also use the average life to get an insight into how fast returns are expected for different investment options. Investors are generally enticed by investment options that bear earlier financial gains, and, as a result, will opt for investments with a shorter average life.
The measure of the average lifespan can also help lenders differentiate between risk factors associated with loans with similar maturities.
How to Calculate the Average Life on a Bond
Different methods are used in calculating average life on securities. However, the standard method for average life is product-specific, given the widespread acceptance of these formulas within their respective market segments.
To calculate the average life of a bond with a single initial draw-down, the date of unit payment of a principal is multiplied by the percentage of total principal paid within the duration. The result is added and then divided by the total size of the issue. The date of each payment is represented as a fraction of months or years.
To illustrate this method, consider a hypothetical situation where a yearly-paying three-year bond comes with a $200 face value. The principal payment for the first term is $90, $60 for the second term, and $30 for the final term. The following formula will calculate the average life for this particular bond:
Average Life = Weighted Total / Face Value of the Bond
The above shows that the bond’s average life is one and a half years against its maturity of three years.
Mortgage-Backed (MBS) and Asset-Backed Securities (ABS)
The average life reflects the average period of time that borrowers are required to settle the loan debt in MBS and ABS. When investing in such types of securities, investors typically buy small portions of the associated debt that is embedded within the security.
The likelihood of delinquent payment by the borrower defines the risks associated with an MBS or ABS.
For example, the 2008 Global Financial Crisis was fueled by inter-only loans that became affordable only to subprime owners. Banking and financial systems came to the verge of collapse until they were rescued through state intervention. The trapped homeowners defaulted massively due to a widened gap between incomes and debts.
Mortgage prices then started to decline, leading to a collapse in the value of the assets held by lending banks and other institutions.
Besides the less severe default risk, prepayment risk is another type of risk that is associated with investing in bonds. It occurs when the bondholder or the borrower, in the case of the mortgage-backed securities, repays the entire principal owed before maturity. The full prepayments reduce the interest to be earned and, eventually, the average life of the investment.
As a result, such a practice denies an investor future interest payments on the part of the principal. Investors who focus on fixed-income securities expect consistent incomes over the defined period, and any reduction in the rate of interest presents unexpected risks.
Thus, bonds with payment risk are typically designed to restrict prepayments by including prepayment penalties.