Weighted Average Coupon (WAC)

Definition

Weighted Average Coupon (WAC) is a measure used in the bond market which calculates the average yield to maturity of a pool of mortgages in terms of interest rates. It is computed by summing up the gross interest rates of each mortgage in the pool, then dividing by the total balance of the group. The WAC provides investors with a more accurate representation of overall portfolio performance.

Phonetic

The phonetics of the keyword: Weighted Average Coupon (WAC) would be: Weighted: /ˈweɪ.t̬ɪd/Average: /ˈæv.ɚ.ɪdʒ/Coupon: /ˈkuː.pɑːn/(WAC): /ˈwæk/

Key Takeaways

1. Definition: Weighted Average Coupon (WAC) is a mean value that provides the weighted-average gross interest rates of the pool of mortgages that comprise a mortgage-backed security (MBS), at issuance.
2. Calculation and Importance: It is calculated by weighing each mortgage by its size in proportion to the aggregate total amount of mortgages. This detail is important for an MBS investor as the rate will determine the future cash flow and ultimate return of the investment.
3. Fluctuation and Risks: The WAC can change over time due to the active nature of the underlying mortgages, as homeowners may significantly pay down their mortgages or refinance them before maturity, which may introduce prepayment risk to MBS investors.

Importance

The Weighted Average Coupon (WAC) is an essential finance term used in business and particularly significant in the mortgage-backed securities (MBS) sector. The WAC represents the average interest rate of all the mortgages underlying a single MBS, weighted by the loan amount. It is crucial because it provides investors with a way to compare potential yield of different MBSs. An MBS with a higher WAC means the underlying mortgages have a higher interest rate, and thus are likely to generate more interest revenue for the investor. However, it also indicates a higher degree of prepayment risk, since a higher mortgage interest rate provides a stronger motivation for borrowers to refinance when rates go down to lower levels. So, the WAC serves as a vital tool for risk assessment and profit potential for investors in the mortgage security market.

Explanation

The Weighted Average Coupon (WAC) represents an important calculation primarily used by mortgage-backed securities (MBS) traders and analysts for assessing the health and risk of a portfolio of mortgages. These individuals operate in an environment of fluctuating interest rates, which significantly impacts the value of mortgage-based investments. By using the WAC, they can measure the average coupon rate of all the underlying mortgages in a pool, giving each loan equal weight proportional to its size relative to the pool’s aggregate amount. Therefore, it helps investors to better understand the interest income they can expect from such a pool, which is an important factor in their overall return-on-investment calculations.Additionally, the WAC can be beneficial in the evaluation of prepayment risk. As mortgages are usually repaid over 10-30 years, there’s a risk that the borrowers could pay off their loans early, particularly in a lowering interest rates environment. This would consequently reduce the income that was expected to be earned from the interest over the loan term. The WAC offers insights into this potential scenario by illustrating the overall rate at which the portfolio would yield over time, allowing traders to make assessments about future income streams and devise safeguards to protect their interests. In summary, the WAC plays a vital role in risk analysis and income projection for investors in mortgage-backed securities.

Examples

1. Mortgage-Backed Securities (MBS): Mortgage-backed securities are a prime example of where WAC is used. MBS bundles loans with varying interest rates which are then sold to investors. The WAC provides an average interest rate for all the loans included in the security, taking into account the loan amount associated with each interest rate. 2. Credit Card Companies: Credit card companies often use WACs when they offer consolidated loans. If a client has multiple debts each with a different interest rate, the company can consolidate these debts into one loan with a WAC that reflects the average interest rate for all debts, adjusting for the amount of each debt.3. Finance in Education Sector: An education loan provider extends loans to students at different interest rates based on individual financial situations. The blended rate extended across all borrowers will be the weighted average coupon (WAC). This helps the institution to balance the risk and return of lending to diverse borrowers.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Mortgage-Backed Securities (MBS)
• Prepayment Rate
• Weighted Average Maturity (WAM)
• Collateralized Mortgage Obligation (CMO)
• Repurchase Agreement (Repo)

Sources for More Information

• Investopedia
• YieldBook Glossary
• S&P Global
• Financial Dictionary