Prepayment Risk
Categories: Bonds, Muni Bonds
Close your eyes and imagine a high-inflation, high-interest-rate world that is slowly crumbling—that is, The Federal Reserve Board is openly flirting with lowering interest rates.
You bought a bond from a corporation, which was going to pay 10% a year for 15 years. Spectacular returns expected. With one hitch: The issuing corporation had the right to buy back its bonds after 3 years for the price of 102 or 2% over par (the bond's actual face value.) Now with prevailing rates tumbling, that corporation thinks it can refinance that debt for 7% instead of 10%, so it makes sense to get rid of those older bonds and, well, start all over.
So, instead of 10 years of feasting on 10% a year returns, they hand you back your principal plus that extra 2%, and you're done.
That's prepayment risk—the risk that you'll have this awesome huge-yielding bond that you thought was going to last forever... only to just get your money back at a slight premium and the fat monthly checks go away.