Yield-to-Average Life
Yield-to-average life is a method of calculating the yield of a bond without reference to the stated maturity of the issue, but on the basis of the average expiration. Yield-to-average life substitutes maturities from established to average. Other names of average life are the weighted average maturity (WAM) and weighted average life (WAL).
What is Yield-to-Average Life
Yield-to-average life helps an investor to accurately determine the return actually received from investing in bonds, independently of the maturity date of a bond.
Figuring the yield-to-average life means bond redemption not at par value, but at the average redemption price and, on the day determined by the average life of this debt investment. To figure out the yield-to-average life, the same formula is used as when calculating the yield to maturity (YTM), the only difference is that the fixed maturity of the bond is changed to the value of average life.
Yield-to-average life defines the time which is required to recover 1/2 of a face value of a bond. To minimize the risk of default and help the bondholder to reinvest funds sooner, bonds having a faster repayment of the principal debt are used. However, such a quick reinvestment can both turn out to be profitable and timely, and vice versa. It depends on the direction in which interest rates have changed since the investor purchased the bond.
The payment of the principal amount of debt on some bonds is made at the time of redemption, but along with this, repayment can also be carried out in installments during the entire term of the bond. The installment repayment method is also known as a sinking fund function. With this type of bonds, the indenture provides for the regular transfer of funds by the issuer to a dedicated account, designated exclusively for the redemption of bonds.
With this principal amortization, the yield-to-average life figuring helps the investor to figure out the rate of repayment of principal debt. Calculation and subsequent applying of the yield-to-average life indicator by a sinking fund bond’s trustee can allow understanding whether to re-purchase certain bonds on the market.
This is quite common when bonds are traded below par. In such a situation, the average life may be substantially less than the actual remaining period to maturity.
A sinking fund is a tool of repaying funds which are taken through a bond issue and made by making periodic payments to a fund trustee who, for his part, repays a portion of the issue by buying the bonds on the current market. A sinking fund enhances the company's creditworthiness, which allows the company to pay the investor lower interest.
Yield-to-Average Life and mortgage-backed securities
Yield-to-average life is a means of determining the prospective profit of mortgage-backed securities (MBS) in connection with the early repayment of the principal mortgage debt.
Yield-to-average life indicator is necessary for the mortgage-backed securities pricing. A good example of assets where the yield-to-average life metric applies is collateralized mortgage obligations (CMOs). The Federal Home Loan Mortgage Corporation (Freddie Mac) is a head issuer of these investments.
An MBS generally repay the principal over the life of the investment. Early repayment of the principal debt may have an impact on the expected return of an investor, and this depends on how MBS was bought at a discount or at a premium.
Homeowners often resort to refinancing their mortgages due to constantly declining interest rates in the market. When refinancing, the existing loan is closed and a new one with a lower interest payment is opened.
