Define Average Life

Average Life

What Is a Typical Day Like?

The average life of a debt issuance refers to how long the principal is projected to remain due. Interest payments are not included in the average life, only principal payments on a loan or security are. The average life of a loan, mortgage, or bond is the time it takes for the debt to be repaid through amortisation or sinking fund payments.

The average life calculation is used by investors and analysts to assess the risk of amortising bonds, loans, and mortgage-backed securities. The calculation provides a helpful indicator for evaluating investment possibilities and gives investors a sense of how soon they might anticipate profits. In general, most investors prefer to obtain their financial rewards sooner and, as a result, will select the investment with the shortest average life.

TAKEAWAYS IMPORTANT

• The typical life of a debt issuance, such as a Treasury bill, bond, loan, or mortgage-backed instrument, is the time it takes to repay the outstanding principal.

• Investors who wish to analyse the risk associated with various assets before making a selection can utilise the average life estimate.

• The majority of investors will choose for an investment with a shorter average life since they would collect their rewards sooner.

• Prepayment risk arises when a loan borrower or bond issuer repays the principle sooner than expected, lowering the investment's average life and reducing the amount of interest received by the investor.

Understanding the Average Person's Life

The average life, also known as the weighted average maturity or weighted average life, is a calculation used to assess how long it will take to pay off a debt issue's outstanding principal, such as a Treasury Bill (T-Bill) or a bond. Some bonds pay the principal in one big payment at maturity, while others pay it in installments during the bond's tenure. The average life of a bond helps investors to predict how soon the principal will be repaid in circumstances where the bond's principal is amortised.

Payments are made according to the terms of the loans that back the security, such as mortgage-backed securities (MBS) and asset-backed securities (ABS) (ABS). Investors get payments reflecting a percentage of the accumulated interest and principal payments as borrowers make payments on the corresponding debt obligations.

Calculating a Bond's Average Life

Multiply the date of each payment (in fractions of years or months) by the proportion of total principal paid by that date, aggregate the findings, then divide by the total issue size to get the average life.

Consider an annual-paying four-year bond with a face value of $200 and principal payments of $80 in the first year, $60 in the second, $40 in the third, and $20 in the fourth (and last) year. This bond's average life would be calculated using the following formula:

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

The average life is calculated by dividing the weighted total by the bond face value. The average life in this case is 2 years (400 divided by 200 = 2).

This bond would have a two-year average life against a four-year maturity.

Securities Backed by Mortgages and Assets

The average life of an MBS or ABS refers to the average amount of time it takes for the connected borrowers to repay the loan obligation. An MBS or ABS investment entails acquiring a tiny share of the debt that is bundled within the instrument.

The risk associated with an MBS or ABS is determined by whether the loan's borrower will default. If the borrower defaults on a payment, the investors who bought the security will lose money. During the 2008 financial crisis, a large number of home loan defaults, especially in the subprime market, resulted in significant losses in the MBS market.

Particular Points to Consider

Another risk that bond investors face is prepayment risk, which isn't as serious as default risk. When a bond issuer (or, in the case of mortgage-backed securities, the borrower) pays back the principal earlier than expected, this is known as prepayment. The average life of the investment will be shortened as a result of these prepayments. The investor will not get future interest payments on that portion of the principle because it was paid back early.

This interest rate cut may provide an unanticipated hurdle for fixed-income investors who rely on a steady source of income. As a result, prepayment penalties are included in some bonds with payment risk.