Identifier: C6T3L3 | Revision: 2026-10-26 | Planned study: 10–15 minutes, excluding extended practice.

Decision and objectives

Decision: Borrower and issuer options make timing a risk: model both early repayment and extension before matching a liability. Objectives: Reconstruct early principal repayment and reinvestment; Explain extension when rates rise; Separate guarantee scope from cash-flow timing. Prerequisite: C6T3L2.

All numerical offers, rates, prices, account chains, fees and contract parameters below are hypothetical, unless a primary document is expressly identified. They are not current executable offers or evidence that a Turkey-resident investor can access them. The assumed investor is a Turkey-resident individual outside a business, with no assumed US citizenship or tax residence; actual classification must be checked. Results are before actual tax unless a fictional tax schedule is explicitly supplied. No account, deposit or trade is required.

Mechanics

A mortgage-backed security passes or allocates borrower cash flows under its structure. Homeowners can prepay, so principal timing is uncertain. A callable bond gives the issuer a specified redemption right. Both can return principal when the investor would prefer to retain a high coupon, creating reinvestment risk. Mortgage tranches allocate principal and losses by different rules; a stated final maturity is not a reliable forecast of cash timing. International agency names and guarantees require exact legal analysis rather than being treated as interchangeable sovereign promises.

Price and return drivers

Calculate income on outstanding principal and stop it when principal is returned. A premium paid above par can be lost if the asset prepays quickly. When rates rise, slower prepayments can extend a mortgage security’s life while its price falls; duration is therefore state-dependent. A single fixed-duration approximation can understate that extension. Credit support may cover defined payments while leaving timing, market price, liquidity and investor FX risks. Use cash-flow scenarios rather than a single promised yield when borrower/issuer options matter.

Worked case

Synthetic pass-through purchased dirty for USD 10200 on 10000 principal, annual 6% coupon, all principal repaid at par after six months; simple actual teaching period uses 180/360. Coupon 10000×0.06×0.5=300. Reinvest 10300 for the remaining six months at supplied 2% simple annual rate: ending 10300×1.01=10403. With 20 total investor costs, net 183 against 10200. Without prepayment, full-year coupon 600 plus 10000 redemption would give 10580 net and 380 gain under a different supplied maturity path; premium amortization and reinvestment can change the ranking, so do not infer it from coupon alone.

Adverse case

Three supplied early-reinvestment rates 0%, 2%, 4% on 10300 produce year-end cash 10300, 10403, 10506; net after 10200 purchase and 20 costs is 80, 183, 286. Separately a rising-rate extension stress leaves the position unredeemed with year-end bid 9000 and coupon 600: net 9000+600−10200−20=−620. These are scenario cash schedules, not an actual MBS model or forecast. Before a planned sale, bid liquidity and accrued interest need explicit reconciliation. A par credit promise does not prevent a premium purchase loss or a delayed cash need.

Practical use

Obtain the prospectus, pool/tranche identity, payment waterfall, prepayment history and assumptions, call provisions, legal credit support and dealer settlement terms. The linked SEC source explains cash-flow risk within its US context; do not import any agency guarantee or tax concession to another issuer or investor.

Before implementation verify the legal entity, jurisdiction, authorized access, actual instrument identifier and full documents. Include bid/ask, commissions, transfer/FX, custody, funding and exit costs; avoid deducting already embedded fund expenses twice. Recheck residency, income year, acquisition dates, withholding, treaty and domestic declaration treatment. Foreign tax concessions or investor protections do not follow automatically from the instrument name or trading currency.

Decision boundaries

Choose only when the uncertain timing can be funded and reinvestment/extension fits the objective. Decline a premium mortgage security proposed as an exact known-date cash match without scenarios. A noncallable direct bond can match a date more clearly, though its issuer and market risks remain. A diversified MBS fund does not automatically return a known principal amount on the investor’s spending date.

Practice and references

Exercise: face 5000, purchase 5100, coupon 8% annual, full par repayment after three months on 90/360, then nine-month reinvestment at 2%, costs 10. Solution: coupon 100; reinvest 5100×(1+0.02×0.75)=5176.50; net 66.50. At zero reinvestment return, net−10. The investor’s paid premium matters even though face was repaid.

Takeaway: Borrower and issuer options make timing a risk: model both early repayment and extension before matching a liability. References: product card, formula; glossary: Prepayment; Extension risk; Callable debt. Next: C6T3L4. Topic test.

Sources: GIB: Investment Income Guide (retrieved 2026-10-26; Introduction and foreign income/reporting framework). SEC: Mortgage Backed Securities and CMOs (retrieved 2026-10-26; Prepayments, tranches and liquidity risk). SEC: Corporate Bonds (retrieved 2026-10-26; Seniority, credit quality and default). Revision: 2026-10-26; recheck changeable rules before publication.

Shared reference guide