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3 Recurring causes of valuation discounts

Part One

Investment Summary

Every investment has some risk. The amount of risk and return determines its attractiveness to individual investors. Some investors are cautious and conservative; some are daring and adventurous. There are investment opportunities that satisfy all types of investors. US government bonds have the lowest risk; they pay the lowest interest rates. Defaulted and defaulted bonds and notes are examples of assets that pay high returns to offset high risks of loss. There is a flavor for all tastes.

Promissory notes: an “intermediate” option

In today’s interest rate environment, an annual return of 5% to 8% is acceptable for regular investors. Investments are available in promissory notes that provide this “intermediate” interest rate. The challenge for the investor is to identify the notes that will provide this return with reasonable assurance. Not all promissory notes are the same. A good appearance does not guarantee good performance.

The fact that a borrower signs a note stating that they will pay 7% per year and repay the investment for five years does not guarantee that this will happen. Often times, a borrower is unable to fulfill the promise due to unforeseen circumstances, or because the promise was based on unrealistic expectations, or because the borrower never intended to fulfill the promise.

Regardless of the reasons for default, the note holder will incur anxiety, annoyance and / or loss of money. Let’s look at three recurring reasons that cause a note to lose value.

Recurring causes of valuation discounts

1. Interest rate too low: Investments are made to receive income. The main determinant of the value of any investment is its ability to generate income. If the interest rate on a note is less than what the investor can receive through a similar competing investment, the value of the low-paying asset will be discounted to compensate for its poor performance. For example: if a note pays 4% and the market rate of a similar asset is 8%, the 4% asset is worth half the value of the 8% asset; the 4% asset must be discounted 50% to offset and become competitive with the 8% asset.

2. The note is not insured; without collateral; just a “naked” promise of repayment: all financial assets reflect the risk of loss in their price. The greater the risk of loss, the greater the return to offset. If a promise to pay a debt is backed or backed only by the promise of a borrower, it is riskier than a similar asset that has both a promise to pay and additional assets backing the promise. Lack of confidence in the borrower’s ability to pay causes the note to have a higher interest rate requirement; If the ticket does not have a high enough nominal rate, it must be discounted to achieve the required rate.

To try to predict the future financial capacity of the borrower, current information must be analyzed. Income and expense statement, profit and loss statements, current income and employment history, credit scores, credit history, and past payment history should be provided and analyzed.

3. There is collateral guarantee, but it is not duly pledged or encumbered. A so-called “secured note” that is improperly secured is potentially more dangerous to the investor than an obviously unsecured note. If the investor falls asleep with a false sense of security believing that the investment is safer than it is, small oversights or omissions can become serious and even fatal threats to the investment.

Examples of situations that create a false sense of security and protection: Collateral is real property, but no Lender Title Policy is provided; collateral exists, but its value is too low to protect the lender’s investment; Collateral exists, but its value is unknown — a current appraisal is not provided.

Resume

Depending on the individual deficiencies and events related to the asset, the discounted value of the note may vary from 90% of the face or face value to a minimum of 5% of the face or face value. Remember, any discount will save on taxes and fees!

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