What it means
When you buy a bond backed by mortgages, the cash you receive depends on what borrowers do. Some keep paying on schedule, but others sell their homes or refinance, and that returns principal early.
SMM captures that behaviour in a single number for one month. The measure is calculated on the balance that could still be prepaid, which is the opening balance after taking off the scheduled principal payment.
Using that adjusted base avoids mixing up normal repayments with unplanned early ones. The result is a monthly rate that analysts can compare from one month to the next.
SMM is most useful when it is annualised, because most prepayment forecasts and market quotes are given on a yearly basis. The annual equivalent is called the conditional prepayment rate, or CPR.
Converting between the two lets a finance team compare a one-month reading with a yearly assumption in a pricing model. The business relevance is mainly about cash flow timing and reinvestment.
If prepayments run faster than expected, investors get cash back sooner and may have to reinvest it at lower interest rates, which reduces their return. Falling interest rates normally push prepayment speeds up, because more borrowers find it worthwhile to refinance.
One nuance is that SMM is volatile from month to month because of seasonality, holidays and the number of working days. Analysts therefore look at averages over several months before drawing conclusions.
The word mortality is borrowed from insurance mathematics, where it describes the share of a group that drops out, and here it describes the share of a loan pool that disappears early. For a risk manager, the habit worth building is to read SMM alongside the interest rate environment and the age of the loans.
Newly issued pools usually prepay slowly at first and then speed up, so a reading that looks alarming on a young pool may be perfectly normal for the later stages of its life.
In practice
Real-world examples.
Example
A fixed-income analyst at a pension fund receives the monthly report on a mortgage pool and sees prepayments of $1,990,000 on a $99,500,000 base. She calculates an SMM of 2.0% and compares it with the 1.5% her model assumed. She concludes cash is coming back faster than planned and adjusts the fund's reinvestment forecast.
Example
A bank that securitises car loans tracks the equivalent measure on its own pools. In a month when interest rates dip, it notices that more borrowers pay off early. The treasury team revises its funding plan because less of the pool will still be outstanding in a year.
Example
A credit rating team reviews a portfolio of commercial loans with a prepayment penalty clause. It finds that SMM is near zero because the penalty makes early repayment expensive. The team treats the pool's cash flows as far more predictable than a similar pool of residential mortgages.
Formula
Calculation
SMM = Prepayments in the month / (Beginning balance - Scheduled principal payment)
Annualised rate: CPR = 1 - (1 - SMM) raised to the power of 12
Suppose a mortgage pool has a beginning balance of $100,000,000. Scheduled principal for the month is $500,000, so the base is 100,000,000 - 500,000 = $99,500,000. Unscheduled prepayments were $1,990,000. SMM = 1,990,000 / 99,500,000 = 0.02, or 2.0%. Annualised, the monthly survival rate of 0.98 raised to the power of 12 is 0.7847, so CPR = 1 - 0.7847 = 0.2153, or about 21.5% a year.Case study
Seen in the real world.
Meridian Capital is an illustrative, fictional fund that holds a portfolio of mortgage-backed bonds. When market interest rates fell sharply, the portfolio manager expected prepayments to rise but wanted to know how much.
Her analyst tracked SMM across each pool and found it moving from 0.8% to 2.4% within a quarter. Annualised, that was a shift from roughly 9% to roughly 25% a year, and the fund was receiving large sums of principal that it had to reinvest at lower yields.
The illustrative lesson is that a bond's stated maturity says little about its true life. By watching SMM, the manager adjusted the portfolio's expected duration and avoided overestimating future income.
Watch out
Common mistakes.
- Dividing prepayments by the full opening balance, when the correct base is the opening balance minus the scheduled principal payment.
- Quoting a monthly SMM as though it were an annual rate, which understates prepayment speed by a factor of roughly twelve.
- Reading one unusually high month as a trend, when seasonality and calendar effects can move SMM sharply in a single period.
Questions
People also ask.
How is SMM linked to CPR?
CPR is the annual version, found by compounding the monthly survival rate, so CPR = 1 - (1 - SMM) raised to the power of 12.
Does a high SMM help or hurt investors?
It depends on the bond: investors who paid above par lose value when principal returns early, while those who paid below par gain.
Does SMM include scheduled repayments?
No, it measures only the unscheduled early repayments, which is why scheduled principal is removed from the base.
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