What Is a Principal Haircut
A principal haircut is a reduction applied to the face value of a bond or loan when it is used as collateral or priced for risk. The haircut equals the difference between the full principal and the amount a lender or market participant is willing to accept. It compensates for default risk, liquidity risk, and price volatility.
How a Principal Haircut Works
In collateralized lending, the lender holds the bond but lends less than its full value. For example, a bond with a principal of 100 may be accepted at 90, creating a 10% haircut. The haircut size often depends on credit quality, maturity, and market liquidity. Lower-rated or longer-dated bonds typically carry larger haircuts.
Why Principal Haircuts Matter
Haircuts protect lenders from losses if collateral values fall. They also influence borrowing costs and leverage in financial markets. Central banks and regulators set haircut schedules for collateral accepted in operations. Investors use haircuts to compare risk-adjusted returns across bonds and structured products.
For standard definitions and examples, see the Investopedia haircut overview.
