Average Life
Candlefocus EditorAverage life can be calculated for any type of security or instrument, such as bonds, loans, and mortgage-backed securities. To calculate an investment's average life, investors look at the amount of principal left to be repaid on the debt instrument, along with the amount of interest received, at multiple points throughout the payment period.
The shorter the average life of the debt instrument, the less volatility the investor will experience, as the return of the principal typically occurs earlier, assuming that the debt issuer pays all due interest payments on time. Therefore, investors may prefer to invest in securities or instruments with a shorter average life in order to minimize risk.
On the other hand, investing in securities with a longer average life offers investors the potential for higher returns over the course of their investment period. This is because longer securities can produce a higher yield for investors who are willing to take on more risk in exchange for the longer term.
In addition, investors must consider the potential for prepayment risk when investing in a debt instrument with a longer average life. Prepayment risk occurs when the loan borrower or bond issuer repays the principal prior to the due date, thereby reducing the average life of the instrument and the amount of interest the investor will receive.
In conclusion, the average life of an investment is an important factor in the overall assessment of risk before making a decision. Investors must consider the length of the investment, the potential for prepayment risk, and the prospective return. When all of these factors are taken into account, investors can make informed decisions about which debt instrument to invest in, and the amount of risk they are willing to take when doing so.