The average life is referred to the length of time around which a debt issue’s principal is anticipated to be outstanding. Average life doesn’t consider interest but only principal repayments made on the security or loan.
In Bonds, mortgages and loans, the average life is referred to as the average time period before a debt is repaid. Analysts and investors use this measure to evaluate the risk linked with mortgage-backed securities, loans, and amortizing bonds. The calculation provides an idea of how quickly returns can be expected. It is also useful while comparing different investment options. Generally, most investors choose to get their financial returns much earlier; thus, they go with an investment that has a shorter average life.
Also known as weighted average life and weighted average maturity, the average life can be calculated to comprehend how long is it going to take to pay the outstanding principal amount. While some of the bonds repay in a lump sum during the time of maturing, others choose to pay in instalments over the bond’s term.
If the principal is amortized, the average life enables investors to comprehend how quickly it will be repaid. Generally, the received payments are on the Basis of the repayment schedule of loans backing specific security. As borrowers pay their debt obligations, investors issue payments that reflect a part of these accumulated principal and interest payments.
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To calculate this metric, you would have to multiply the date of every payment with the percentage of the total principal that is repaid by now. After that, add the results and divide the same with the total issue size.
For example, let’s assume that an annual-paying bond that has a lock-in period of 4 years has a Face Value of Rs. 200. Its principal payments of Rs. 80 in the first year, Rs. 60 in the second year, Rs. 40 in the third year and Rs. 20 in the fourth year have been received.
Now, to measure the average life, a formula that will be used is:
(Rs. 80 x 1) + (Rs. 60 x 2) + (Rs. 40 x 3) + (Rs. 20 x 4) = 400
Now, the weighted total will be divided by the bond face value to acquire the average life. In the example mentioned above, the average life is:
400 / 200 = 2