What it means
When investors buy a bond backed by a pool of home loans, they do not know when each borrower will repay early. The PSA benchmark gives them a common yardstick for assuming how quickly the pool pays down, so two bonds can be compared on the same basis.
The standard pattern starts slowly and speeds up. In the first month the assumed annual prepayment rate is 0.2%, it rises by another 0.2% each month until month 30, and from then on it stays level at 6%.
Analysts scale this pattern up or down. A pool described as 150% PSA is assumed to prepay one and a half times as fast as the base pattern, and a pool at 50% PSA is assumed to prepay at half the speed.
Speed matters because it changes both the return and the life of the investment. Faster prepayments shorten the average life of the bond and hand investors their money back sooner, which hurts when rates have fallen and they must reinvest at lower yields.
The Public Securities Association is no longer a separate body, since its work passed to its successor organisations, but the benchmark is still widely used. Some markets prefer conditional prepayment rates quoted directly, and PSA remains useful mainly for pricing and quoting mortgage securities.
In practice, traders often quote a bond at several speeds so a buyer can see how the price changes. A bond bought above face value loses more if prepayments speed up, while a bond bought below face value gains from faster repayment because the discount is recovered sooner.
In practice
Real-world examples.
Example
A bank trader quotes a mortgage-backed bond at a price assuming 150% PSA. A buyer who expects faster prepayments, because interest rates have dropped, asks for a lower price to reflect the shorter life. The seller counters with data on the pool's past speeds to defend the higher price.
Example
A portfolio manager at an insurance company stress-tests her bond holdings at 100%, 200% and 300% PSA. The results show how the average life of her portfolio could fall from nine years to five if refinancing booms.
Example
An operations director at a consulting firm sees PSA in a procurement email and checks whether it means a purchase and sale agreement, which is a contract to buy and sell a property or business, rather than the mortgage benchmark.
Formula
Calculation
Annual prepayment rate (CPR) at month n, for n up to 30 = 0.2% x n x (PSA speed / 100)
After month 30, CPR = 6% x (PSA speed / 100)
For example, take a mortgage pool at 150% PSA. At month 20 the base rate is 0.2% x 20 = 4.0%, and scaling by 150/100 gives 4.0% x 1.5 = 6.0% a year. At month 40 the base rate has levelled at 6%, so the pool prepays at 6% x 1.5 = 9.0% a year. On a $200,000,000 pool, a 9.0% annual rate means roughly $18,000,000 of principal is assumed to be repaid early over the following year.Case study
Seen in the real world.
Lakeshore Income Partners is an illustrative, fictional investment firm that bought a mortgage-backed bond priced at 100% PSA. Soon after, mortgage rates fell sharply and homeowners began refinancing.
The firm's analyst reran the model at 250% PSA and found that the bond's average life had shortened by several years. The bond had been bought at a premium, so faster repayment meant the premium was being lost more quickly than expected.
The firm used the new assumption to reprice the holding and moved some money to bonds with less prepayment sensitivity. The illustrative lesson is that a prepayment speed is an assumption, and it needs to be refreshed when rates move.
Watch out
Common mistakes.
- Treating PSA as a forecast, when it is a convention used to quote and compare, and actual prepayments can differ widely.
- Assuming 100% PSA means 100% of the loans repay, when it describes a standard pattern of annual rates starting at 0.2% and levelling at 6%.
- Ignoring context, since PSA can also mean purchase and sale agreement or a software category in other business settings.
Questions
People also ask.
What does 200% PSA mean?
It means prepayments are assumed to run at twice the speed of the standard pattern, so the pool pays down much faster.
Why do prepayments matter to a bond investor?
Early repayment changes the timing of cash flows and the bond's average life, which affects both the yield achieved and the price the investor should pay.
Is the PSA benchmark the same as CPR?
No, CPR is the actual or assumed annual prepayment rate, while PSA is a standard pattern from which a CPR is derived for each month.
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