What Is Average Life?

The average life is the length of time the principal of a debt issue is expected to be outstanding. Average life does not take into account interest payments, but only principal payments made on the loan or security. In loans, mortgages, and bonds, the average life is the average period of time before the debt is repaid through 澳洲幸运5开奖号码历史查询:amortization or 澳洲幸运5开奖号码历史查询:sinking fund payments.

Investors and analysts use the average life calculation to measure the risk associated with amortizing bonds, loans, and mortgage-backed securities. The calculation gives investors an idea of how quickly they can expect returns and provides a useful metric for comparing investment options. In general, most investors will choose to receive their 澳洲幸运5开奖号码历史查询:financial returns earlier and ꩲwill, therefore, choose the investment with𝓡 the shorter average life.

Understanding Average Life

Also called the weighted average maturity and 澳洲幸运5开奖号码历史查询:weighted average life, the average life is calculated to determine how long it will take to pay the outstanding principal of a debt issue, such as a 澳洲幸运5开奖号码历史查询:Treasury Bill (T-Bill) or bond. While some bonds repay the principal in a lump sum at maturity, others repay the principal in installments ov🐈er the term 🧔of the bond. In cases where the bond's principal is amortized, the average life allows investors to determine how quickly the principal will be repaid.

The payments received are based on the repayment schedule of the loans backing the particular security, such as with 澳洲幸运5开奖号码历史查询:mortgage-backed securities (MBS) and 澳洲幸运5开奖号码历史查询:asset-backed securities (ABS). As borrowers make payments on the a🉐ssociated debt obligations, investors are issued payꦕments reflecting a portion of these cumulative interest and principal payments.

Calculating the Average Life on a Bond

To calcul🗹ate the average life, multiply the date of each payment (expressed as a fraction of years or months) by the percentage of total principal that has been paid by that date, add the results, and divide by the total issue size.

For example, assume an annual-paying four-year bond has a 澳洲幸运5开奖号码历史查询:face value of $200 and principal payments of $80 during the𒐪 first year, $60 for the second year, $40 during the third year, and $20 for the fourth (and final) year. The average life for this bond would be calculated with the following formula:

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

Then divide the weighted total by the bond face value to get the average life. In this example, the average life equals 2 years (400 divided by 200 = 2).

This bond would have an average life of two years against its maturity of four years.

Mortgage-Backed and Asset-Backed Securities

In the case of an MBS or ABS, the average life represents the average length of time requꦗired for the associated borrowers to repay the loan debt. An investment in an MBS or ABS involves purchasing a small portion of the associated debt that is packaged within the security.

The risk associated with an MBS or ABS centers on whether the borrower associated with the loan will default. If the borrower fails to make a payment, the investors associated with the security will experience losses. In the 澳洲幸运5开奖号码历史查询:financial crisis of 2008, a large number of defaults on home loans, particularly in the subprime market, led to significant losses in the MBS arena.

Special Considerations

While certainly not as dire as 澳洲幸运5开奖号码历史查询:default risk, another risk bond investors face is 澳洲幸运5开奖号码历史查询:prepayment risk. This occurs when the bond issuer (or the borrower in the case of mortgage-backed securities) pays back the principal earlier than scheduled. These prepayments will reduce the average life of the investment. Becaꦓuse the principal is paid back early, the investor will not receive future interest payments on that p🐓art of the principal.

This interest reduction can represent an unexpected challenge for investors of fixed-income securities dependent on a reliable stream of income. For this reason, some bonds with payment risk include 澳洲幸运5开奖号码历史查询:prepayment penalties.