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 overdue bonds and notes are examples of assets that pay high yields to offset high risks of loss. There is a flavor for every taste.

Notes: a “middle of the road” option

In the current interest rate environment, an annual return of 5-8% is acceptable to typical investors. Investments in notes are available and offer this “intermediate” interest rate. The challenge for the investor is to identify those notes that will provide this return with reasonable certainty. Not all IOUs are created equal. A good appearance does not ensure good performance.

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

Regardless of the reasons for default, the note holder will incur anxiety, inconvenience, and/or loss of money. Let’s look at three recurring reasons that cause a promissory note to suffer a loss of 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 produce 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. As an example: If a note pays 4% and the market rate for 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 compensate and become competitive with the 8% asset.

2. The promissory note is not secured; no collateral; just a “naked” promise to pay: all financial assets reflect the risk of loss in their price. The higher the risk of loss, the higher the return must be to compensate. If a promise to pay a debt is backed or supported only by the borrower’s promise, it is riskier than a similar asset that has a promise to pay and additional assets backing the promise. Lack of confidence in the borrower’s ability to pay causes the note to carry a higher interest rate requirement; If the note does not have a high enough face rate, it must be discounted to achieve the necessary rate.

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

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

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

Summary

Depending on individual deficiencies and facts relating to the asset, the discounted value of the promissory note can range from 90% of face or face value to as little as 5% of face or face value. Remember, any discount will result in tax and fee savings!