What Is Average Life?
The average life is the length of time the principal of a debt issue is expected to be outstanding. Average life does not take into account interest payments, but only principal payments made on the loan or security. In loans, mortgages, and bonds, the average life is the average period of time before the debt is repaid through amortization or sinking fund payments.
Investors and analysts use the average life calculation to measure the risk associated with amortizing bonds, loans, and mortgage-backed securities. The calculation gives investors an idea of how quickly they can expect returns and provides a useful metric for comparing investment options. In general, most investors will choose to receive their financial returns earlier and will, therefore, choose the investment with the shorter average life.
Key Takeaways
- The average life is the average length of time it will take to repay the outstanding principal on a debt issue, such as a Treasury bill, bond, loan, or mortgage-backed security.
- The average life calculation is useful for investors who want to compare the risk associated with various investments before making an investment decision.
- Most investors will choose an investment with a shorter average life as this means they will receive their investment returns sooner.
- Prepayment risk occurs when the loan borrower or bond issuer repays the principal earlier than scheduled, thereby shortening the investment's average life and reducing the amount of interest the investor will receive.
Understanding Average Life
Also called the weighted average maturity and weighted average life, the average life is calculated to determine how long it will take to pay the outstanding principal of a debt issue, such as a Treasury Bill (T-Bill) or bond. While some bonds repay the principal in a lump sum at maturity, others repay the principal in installments over the term of the bond. In cases where the bond's principal is amortized, the average life allows investors to determine how quickly the principal will be repaid.
The payments received are based on the repayment schedule of the loans backing the particular security, such as with mortgage-backed securities (MBS) and asset-backed securities (ABS). As borrowers make payments on the associated debt obligations, investors are issued payments reflecting a portion of these cumulative interest and principal payments.
Calculating the Average Life on a Bond
To calculate the average life, multiply the date of each payment (expressed as a fraction of years or months) by the percentage of total principal that has been paid by that date, add the results, and divide by the total issue size.
For example, assume an annual-paying four-year bond has a face value of $200 and principal payments of $80 during the first year, $60 for the second year, $40 during the third year, and $20 for the fourth (and final) year. The average life for this bond would be calculated with the following formula:
($80 x 1) + ($60 x 2) + ($40 x 3) + ($20 x 4) = 400
Then divide the weighted total by the bond face value to get the average life. In this example, the average life equals 2 years (400 divided by 200 = 2).
This bond would have an average life of two years against its maturity of four years.
Mortgage-Backed and Asset-Backed Securities
In the case of an MBS or ABS, the average life represents the average length of time required for the associated borrowers to repay the loan debt. An investment in an MBS or ABS involves purchasing a small portion of the associated debt that is packaged within the security.
The risk associated with an MBS or ABS centers on whether the borrower associated with the loan will default. If the borrower fails to make a payment, the investors associated with the security will experience losses. In the financial crisis of 2008, a large number of defaults on home loans, particularly in the subprime market, led to significant losses in the MBS arena.
Special Considerations
While certainly not as dire as default risk, another risk bond investors face is prepayment risk. This occurs when the bond issuer (or the borrower in the case of mortgage-backed securities) pays back the principal earlier than scheduled. These prepayments will reduce the average life of the investment. Because the principal is paid back early, the investor will not receive future interest payments on that part of the principal.
This interest reduction can represent an unexpected challenge for investors of fixed-income securities dependent on a reliable stream of income. For this reason, some bonds with payment risk include prepayment penalties.
FAQs
Yield-to-average life is the calculation of a bond's yield based on the average maturity rather than the stated maturity date of the issue. This yield replaces the stated final maturity with the average life maturity. Average life is also called the weighted average maturity (WAM) or weighted average life (WAL).
How is average life calculated? ›
Generally, the Average Life is equal to (a) the product of the number of Bonds times the number of years from issuance to Maturity divided by (b) the total number of Bonds; for these purposes, a “Bond” is each $1,000 Par amount, regardless of actual denomination.
How do you calculate average term to maturity? ›
How is average maturity calculated ? Average maturity is calculated by multiplying the time to maturity of each loan or security in a portfolio by its respective share of the total value of the portfolio, and then summing the results. The total is then divided by the total value of the portfolio.
What is the formula for the average life of a loan? ›
To calculate the average life, multiply the date of each payment (expressed as a fraction of years or months) by the percentage of total principal that has been paid by that date, add the results, and divide by the total issue size.
What is the difference between maturity and weighted average life? ›
So while the 'Term” or maturity of two cases might be the same, their Weighted Average Life, or the average amount of time each dollar of principal is invested, may be widely different. The WAL, therefore, is a more accurate way of comparing.
What is the difference between weighted average life and maturity? ›
WAL focuses on the average time it takes for the principal amount to be repaid, considering the timing of future cash flows. Maturity, on the other hand, represents the fixed date on which the principal amount is due.
What is the average formula for? ›
Average This is the arithmetic mean, and is calculated by adding a group of numbers and then dividing by the count of those numbers. For example, the average of 2, 3, 3, 5, 7, and 10 is 30 divided by 6, which is 5. Median The middle number of a group of numbers.
How to calculate weighted average life to maturity? ›
Generally, the Weighted Average Maturity of a Bond Issue is the sum of the product of the Issue Price of each maturity of the Bond Issue multiplied by the number of years from the Closing until that Maturity Date divided by the Issue Price of the entire Bond Issue.
What does average maturity mean? ›
A bond's maturity date indicates the specific future date on which an investor gets his principal back i.e. the borrowed amount is repaid in full. Average Maturity is the weighted average of all the current maturities of the debt securities held in the fund.
How do you calculate maturity value? ›
The Maturity Value (MV) of a loan is the sum of the principal P plus the interest I. In Example 1, Jo borrowed $2000 at an interest rate of 5%. At the end of one year Jo owed $100 in interest. The maturity value of the loan is MV = P + I where P = $2000 and I = $100.
The longer the average maturity, the higher the interest rate risk. The Macaulay Duration of a bond indicates its average lifetime, taking into account the flow of future coupon payments. Modified duration indicates how much the fund's price varies in response to changes in interest rates or yield to maturity (YTM).
What is the average maturity rate? ›
The average maturity is the weighted average of the maturities of all the outstanding bonds in a portfolio. The weights are based on the market value of the bonds. The average maturity is used to measure a bond portfolio's sensitivity to changes in interest rates.
What is the difference between duration and average life? ›
Relationship between duration and weighted average life: Duration and WAL are closely related but distinct measures. Duration measures the sensitivity of a bond's price to interest rate movements, while WAL represents the average time it takes to receive the bond's cash flows.
What is the yield to average life? ›
The yield to average life is the yield on a security based on the security's average maturity rather than the maturity date of the issue. The concept is usually applied to bonds with sinking funds, which are often retired early and thus have shorter lives than their maturity dates suggest.
What is the average life expectancy? ›
Life expectancy at birth, in years, 1980-2022
In 2022, the CDC estimates life expectancy at birth in the U.S. increased to 77.5 years, up 1.1 years from 76.4 years in 2021, but still down 1.3 years from 78.8 years in 2019, before the COVID-19 pandemic.
What is the average life to maturity? ›
Average Life to Maturity means, as at any day with respect to any Indebtedness, the quotient obtained by dividing (a) the sum of the products of (i) the number of years from such day to the date or dates of each successive principal or redemption payment of such Indebtedness multiplied by (ii) the amount of each such ...
What is the definition of average life? ›
Average life: The average life of a radioactive substance is given by the ratio of the total lifetime of all the individual parent atoms to the total number of nuclei. Half-life: Half-life is the time during which half the number of radioactive atoms present initially in the sample of element decay.
What is meant by average life period? ›
mean life, in radioactivity, average lifetime of all the nuclei of a particular unstable atomic species. This time interval may be thought of as the sum of the lifetimes of all the individual unstable nuclei in a sample, divided by the total number of unstable nuclei present.
