What Is Yield-to-Average Life?
When determining a bond’s yield, yield-to-average life considers the average maturity instead of the stated maturity date. This yield uses average life maturity instead of the indicated terminal maturity. Weighted average life (WAL) or weighted average maturity (WAM) are other names for average life.
Understanding Yield-to-Average Life
Regardless of the bond’s precise maturity date, yield-to-average life allows the investor to determine the actual return on their bond investment. When calculating yield-to-average energy, it is assumed that the bond would mature at the average redemption price rather than the par amount on the day specified by its average life. Replacing the bond’s maturity with its average life may be computed using the same method as yield to maturity (YTM).
Yield-to-average life determines the time required to recover half of a bond’s face value. Bonds with accelerated principal payments reduce default risk and enable bondholders to reinvest their money sooner. Depending on how interest rates have changed since the investor purchased the bond, faster reinvestment may be advantageous or disadvantageous.
Certain bonds have a one-time principal repayment at maturity, while others have periodic principal repayments over the bond’s tenure. This repayment plan in installments is referred to as a sinking fund feature. The indenture for these bonds mandates that the issuer make regular deposits into a different account.
The redemption of the bonds is the only use for this account. When the principal of a bond is amortized, investors can ascertain when the principal will be repaid by using the average life calculation.
The yield-to-average-life computation is a tool that sinking fund bond trustees use to assess whether to repurchase part of the bonds on the open market. When the bonds are trading below par, this is normal. In this instance, the average life can be much shorter than the actual years until adulthood.
By making recurring payments to a trustee who retires a portion of the issue by buying the bonds on the open market, a sinking fund serves as a mechanism for paying back money borrowed via the issuance of bonds. A sinking fund helps a company become more creditworthy so that it may offer investors a cheaper interest rate.
Yield-to-Average Life for Mortgage-Backed Securities
Because the underlying mortgage loan is repaid, investors may calculate the projected return of mortgage-backed securities (MBS) using yield-to-average energy. This statistic is helpful when pricing MBSs, such as the collateralized mortgage obligations (CMOs) that the Federal Home Loan Mortgage Corporation (Freddie Mac) and private issuers issue.
Typically, an MBS pays back the principal throughout the investment. The anticipated return of an investor may change whether the MBS was acquired at a premium or a discount. This is because the principal must be paid in advance.
A declining interest rate environment frequently prompts refinancing by homeowners. The previous loan is paid off during the refinancing procedure, and a new loan with reduced interest payments takes place.
Conclusion
- The yield on a bond is calculated using yield-to-average life, which uses the average maturity instead of the issue’s stated maturity date.
- Yield-to-average life determines the time required to recover half of a bond’s face value.
- Sinking fund bond trustees will use the yield-to-average-life computation to help them decide whether to repurchase some bonds on the open market.
