Understanding Average Life: Definition, Calculation, and Comparison to Maturity

What Is Average Life?

Average life is the time period that a debt's principal is expected to remain outstanding. It involves only principal payments rather than principal and interest payments. Average life calculations can help investors understand when to expect returns and to assess the risk of amortizing fixed income securities. Prepayments and defaults can affect average life. Investors can use average life to compare and select from investment opportunities.

How to Assess Average Life in Bonds and Securities

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.

Payments depend on the loan repayment schedules backing the security, such as a mortgage-backed security (MBS) or asset-backed security (ABS). As borrowers make payments on the associated debt obligations, investors are issued payments reflecting a portion of these cumulative interest and principal payments.

How to Calculate Average Life for Bonds

1. Identify the bond’s payment schedule, listing the dates and amounts.
2. Convert the payment dates into fractional years.
3. Multiply each date by the percentage of total principal repaid by that date.
4. Sum these results.
5. Divide the total by the bond's face value to find the average life.

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.

Exploring Average Life in 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 misses a payment, investors in the security may face 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.

Key Risks in Average Life Calculations

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.

Reduced interest can be a challenge for fixed-income investors relying on steady income. For this reason, some bonds with payment risk include prepayment penalties.

The Bottom Line

Average life refers to the time period projected for the repayment of outstanding principal on a debt issue. The average life calculation excludes interest payments. A useful metric when comparing investment options, its assessment of risk and the repayment timeline can assist the selection of investments—investors typically prefer shorter average life investments, as they can yield quicker returns. However, the risks of prepayment and default can affect the average life of an investment, particularly mortgage- and asset-backed securities.