What Is Weighted Average Life (WAL)?
Weighted Average Life (WAL) is a vital metric that calculates the average time each dollar of unpaid principal on a loan, mortgage, or amortizing bond remains outstanding. This measure offers investors, analysts, and portfolio managers insight into the repayment timeline and the credit risk of fixed-income securities. By measuring the WAL, one can determine how long it will take roughly to recover half of the outstanding principal. This understanding is key to assessing the risk-return profile of different investment options.
Understanding Weighted Average Life (WAL)
Weighted Average Life calculations focus on payments to the principal. Unlike total payments, principal payments grow over time. For instance, in the case of a mortgage, early payments are more interest-heavy, whereas later installments focus primarily on reducing the principal. Consequently, calculating WAL involves weighting these principal payments by their timing.
Key Takeaways
- Purpose: WAL helps determine the outstanding principal balance timeline for mortgages, loans, or bonds.
- Weighted Calculations: The calculation assesses the timing and amount of principal payments. Payments closer together result in a lower WAL.
- Exclusion of Interest: WAL calculations ignore interest payments, focusing solely on principal repayment.
- Investment Decisions: Investors often favor bonds with shorter WALs as they generally carry lower credit risk.
A Closer Look: WAL Calculation
Time periods with higher dollar amounts in repayment weigh more significantly in WAL calculations. For example, if the majority of principal payments occur later in the repayment period, the WAL will be closer to that timeframe.
Weighted Average Life Example
Let’s go through a step-by-step example by assuming a bond that makes one annual payment over five years. The payments are as follows: $1,000, $2,000, $4,000, $6,000, and $10,000. The total value of unweighted payments is $23,000.
Steps for WAL Calculation:
- Multiply Each Payment by Its Timing:
- Year 1: $1,000 x 1 = $1,000
- Year 2: $2,000 x 2 = $4,000
- Year 3: $4,000 x 3 = $12,000
- Year 4: $6,000 x 4 = $24,000
- Year 5: $10,000 x 5 = $50,000
- Sum the Weighted Payments:
- Total weighted amount: $1,000 + $4,000 + $12,000 + $24,000 + $50,000 = $91,000
- Sum the Unweighted Payments:
- Total unweighted amount: $23,000
- Divide the Sum of Weighted Payments by the Unweighted Payments:
- WAL = $91,000 / $23,000 = 3.96 years
In this scenario, the WAL of 3.96 years indicates the average time over which the principal is expected to be repaid. This aligns closely with receiving a substantial portion of principal just after four years.
If the payment structure changed, for instance swapping the payments in year two and year five:
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Year 1: $1,000 x 1 = $1,000
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Year 2: $10,000 x 2 = $20,000
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Year 3: $4,000 x 3 = $12,000
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Year 4: $6,000 x 4 = $24,000
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Year 5: $2,000 x 5 = $10,000
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Total weighted amount: $67,000
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WAL = $67,000 / $23,000 = 2.91 years
This demonstrates how WAL provides insight into the bond’s repayment speed. A lower WAL value shows quicker repayment and, generally, lower credit risk. Consequently, many investors choose bonds with shorter WALs to reduce risk and enhance earlier cash flow recovery.
Related Terms: Credit Risk, Fixed-Income Securities, Principal Payment, Investment Strategy.
