what is prepayment risk 
prepayment risk is the risk involved with the premature return of principal on a fixed income security when debtors return part of the principal early they do not have to make interest payments on that part of the principal that means investors in associated fixed income securities will not receive interest paid on the principal the prepayment risk is highest for fixed income securities such as callable bonds and mortgage backed securities mbs bonds with prepayment risk often have prepayment penalties understanding prepayment riskprepayment risk exists in some callable fixed income securities that may be paid off early by the issuer or in the case of a mortgage backed security the borrower these features give the issuer the right but not the obligation to redeem the bond before its scheduled maturity with a callable bond the issuer has the ability to return the investor s principal early after that the investor receives no more interest payments issuers of noncallable bonds lack this ability consequently prepayment risk which describes the chance of the issuer returning the principal early and the investor missing out on subsequent interest is only associated with callable bonds for mortgage backed securities mortgage holders may refinance or pay off their mortgages which results in the security holder losing future interest because the cash flows associated with such securities are uncertain their yield to maturity cannot be known for certain at the time of purchase if the bond was purchased at a premium a price greater than 100 the bond s yield is then less than the one estimated at the time of purchase criticism of prepayment riskthe core problem with prepayment risk is that it can stack the deck against investors callable bonds favor the issuer because they tend to make interest rate risk one sided when interest rates rise issuers benefit from locking in low rates on the other hand bond buyers are stuck with a lower interest rate when higher rates are available there is an opportunity cost when investors buy and hold bonds in a rising rate environment from a total return perspective bondholders also suffer a capital loss when interest rates rise 