While you might dish out money toward a mortgage, car, or other loan payment each month, there are investments you can buy to profit from these types of loans. Mortgage-backed and asset-backed securities, or MBS and ABS, are investments in a pool of loans. Owners of these investments get a piece of the loans’ monthly principal and interest payments. The weighted average maturity, or WAM, of one of these securities is the average number of months until the loans are paid off. A higher WAM means that you can expect to receive payments for a longer period of time than a lower WAM indicates.
TL;DR (Too Long; Didn't Read)
The weight average maturity can generally be defined the average number of months that must pass before a loan is paid off.
Determine the Balance
Find out the outstanding principal balance and number of months until maturity of each loan in the security from your broker or the security’s issuer. For example, assume the mortgages in an MBS have $300,000, $250,000, $275,000 and $350,000 outstanding balances and 230, 275, 190 and 200 months until maturity, respectively.
Add the Relevant Balances
Add the loan balances to determine the total balance of the pool of loans. In this example, add the balances to get a total balance of $1,175,000. Divide each loan balance by the total balance to determine the weight of each loan. In this example, divide $300,000 by $1,175,000 to get a weight of 0.255 for the first loan. The weights for the second through fourth loans are 0.213, 0.234 and 0.298, respectively.
Determine Months to Maturity
Multiply each loan’s weight by the number of months until it matures. In this example, multiply 0.255 by 230 to get 58.65 for the first loan. The results for the second through fourth loans are 58.58, 44.46, and 59.6, respectively. Add your results to calculate the security’s weighted average maturity. Concluding the example, add 58.65, 58.58, 44.46 and 59.6 to get a weighted average maturity of 221.29 for the MBS. This means that, on average, the loans in the MBS have 221.29 months until they mature.
Other Critical Considerations
Compare the weighted average maturities among different securities to determine which one is expected to be a longer-term investment. While WAM gives you a ballpark idea of how long a security will make payments, it fails to reveal the quality of the underlying loans or the creditworthiness of the borrowers. Always research an investment to make sure it satisfies your risk tolerance and investment objective. If one of the loan borrowers prepays all or a portion of her loan or defaults on her loan, the security’s WAM will decrease.
References
Tips
- Compare the weighted average maturities among different securities to determine which one is expected to be a longer-term investment.
Warnings
- While WAM gives you a ballpark idea of how long a security will make payments, it fails to reveal the quality of the underlying loans or the creditworthiness of the borrowers. Always research an investment to make sure it satisfies your risk tolerance and investment objective.
- If any of the loan borrowers prepays all or a portion of her loan or defaults on her loan, the security’s WAM will decrease.