Yield by repayment year with and without a prepayment premium, the probability-weighted value, and what the premium actually compensates.
Call protection adds the most yield exactly when the loan is repaid early. On a five-year loan at S+600 with SOFR at 4.00 per cent, issued at 98, a 102/101 schedule lifts the yield on a year-one repayment from 12.24 to 14.29 per cent and on a year-two repayment from 11.17 to 11.65. Weighted across an illustrative repayment profile it is worth about 43 basis points a year, not two points.
Worked in full in The Private Credit Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Sponsor-backed direct loans are refinanced, repriced or repaid on a sale long before maturity. The prepayment premium is the lender's price for that option. The question a credit committee should ask is not "what is the premium" but "what does it add to the return we expect, given when we think we will be repaid".
| Input | Value |
|---|---|
| Position | $150.0m |
| Issue price (OID of 2.0 points) | 98.0 |
| SOFR, held flat (illustrative) | 4.00% |
| Spread | 6.00% |
| Cash coupon | 10.00% |
| Maturity | 5 years |
| Call protection | 102 / 101 / par |
Build the lender's cash flows for each possible repayment date: pay 98 today, receive the 10.00 coupon each year, receive par plus any premium on the repayment date. Solve for the internal rate of return.
Without protection: −98 today, 110.00 in a year. Yield = 110 ÷ 98 − 1 = 12.24%
With 102: −98 today, 112.00 in a year. Yield = 112 ÷ 98 − 1 = 14.29%
For later years, put the flows in B1:B6 and use =IRR(B1:B6), with the premium added to the final cell.
| Repaid in year | Repayment price | Yield, no protection | Yield, 102/101 | Uplift, bp |
|---|---|---|---|---|
| 1 | 102 | 12.24% | 14.29% | 204 |
| 2 | 101 | 11.17% | 11.65% | 48 |
| 3 | 100 | 10.82% | 10.82% | 0 |
| 4 | 100 | 10.64% | 10.64% | 0 |
| 5 | 100 | 10.53% | 10.53% | 0 |
Two things happen in the same column. The OID is earned over fewer years when the loan is repaid early, so the unprotected yield already rises as the life shortens. The premium then sits on top, and it is a one-off amount divided by a short life: 2 points over one year is 204 basis points, 1 point over two years is 48.
No one knows the repayment date, so the premium has to be valued across a profile. The one below is illustrative, with an expected life of 3.00 years, which is the convention behind the "yield to three years" many lenders quote.
| Repaid in year | Probability | Premium, points |
|---|---|---|
| 1 | 15% | 2.0 |
| 2 | 25% | 1.0 |
| 3 | 25% | 0.0 |
| 4 | 15% | 0.0 |
| 5 | 20% | 0.0 |
| Expected | 100% | 0.55 |
Probability-weighted yield without protection = 11.04%
Probability-weighted yield with 102/101 = 11.46%
Value of the call protection = 11.46 − 11.04 = 43 bp a year
In Excel: =SUMPRODUCT(probabilities, yields_with) - SUMPRODUCT(probabilities, yields_without)
The expected premium is 0.55 points, or $0.825m on the $150.0m position. The headline "2 points of call protection" is a ceiling the lender collects only in the 15 per cent of outcomes where the borrower goes in year one.
| Schedule | Year 1 yield | Year 2 yield | Weighted yield | Uplift, bp | Expected premium |
|---|---|---|---|---|---|
| None | 12.24% | 11.17% | 11.04% | 0 | 0.00 |
| 101 in year 1 | 13.27% | 11.17% | 11.19% | 15 | 0.15 |
| 102/101 | 14.29% | 11.65% | 11.46% | 43 | 0.55 |
| 103/102/101 | 15.31% | 12.13% | 11.81% | 77 | 1.20 |
Moving from 102/101 to 103/102/101 adds 34 basis points of weighted yield, more than three quarters of what 102/101 itself is worth, because every step rises a point and a quarter of the profile repays in year three, where the shorter schedule pays nothing. A lender asked to drop a step should price it against that figure, not against the headline point.
The mistake is to treat the premium as a gain. It is compensation, and usually partial. Borrowers refinance when spreads have tightened or credit has improved, which is when the lender can least replace the asset at the same price. If the loan is repaid in year one and the best replacement pays 100 basis points less, the lost spread over the remaining four years is worth 3.13 points discounted at the 10.53 per cent maturity yield. The 2 point premium covers 64 per cent of it. Repaid in year two, the 1 point premium covers 41 per cent of the 2.46 points lost.
The repayment profile is not independent of the market. The probabilities above are held fixed for clarity. In practice early repayment is more likely in exactly the scenarios where reinvestment is worst, so the weighted 43 basis points measures the premium collected, not the lender's net outcome: after reinvesting at tighter spreads, the all-in return is lower. The weighted figure is also an average of yields by repayment year, a convenient approximation rather than the yield of the expected cash flows.
The OID side of the same arithmetic is worked in how many basis points of spread a point of OID is worth, and the book's own pricing example, with the yield by repayment year it leaves out, is in the free workbooks for this case.
The borrower may repay at any time but pays a premium: 102 per cent of par if it repays in the first year, 101 in the second, par afterwards. On a $150m position that is $3.0m of extra cash in year one and $1.5m in year two. It is a prepayment premium, not a prohibition, so it prices the option rather than removing it.
No. A make-whole pays the present value of the coupons the lender loses until a set date, so it moves with rates and is usually far larger. A fixed 102/101 schedule is a flat fee. In the worked case a year-one 2 point premium covers 64 per cent of the value of a 100 basis point spread tightening over the remaining four years.
Because sponsor-backed loans are rarely held to maturity. In the illustrative profile the expected life is 3.00 years. Yield to maturity on the worked loan is 10.53 per cent; repaid in year three it is 10.82, because the OID is earned over fewer years. Quoting the maturity yield understates what the lender expects to earn.
This article is one calculation from The Private Credit Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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