A performing note at a 12 percent stated yield can still return 7 percent if the timing goes wrong

A note I keep turning over as a study case: face value 85,000, rate 8.5 percent, 22 years remaining, seller carrying it on a paid-down single-family. Buyer prices it at 68 cents, so 57,800 out of pocket, and the yield calculator hands back 12.1 percent to maturity. Clean pay history, no modifications, good collateral equity. The model looks tight.

The assumption doing all the weight in that number is time. Twelve percent to maturity only pays if the borrower runs to month 264. What the model does not show is what happens in the first 36 months, which is where performing notes most often leave the buyer's hands, whether by payoff, refinance, default, or a discounted sale to someone else.

Run the same note at month 18 payoff, borrower refinances at a local credit union, and the buyer collects 18 payments at the note rate plus gets face value back, not the discounted price. That sounds fine until you model the actual dollars: 18 payments on 85,000 at 8.5 percent come to roughly 13,200 in interest received, split between principal and interest by amortization, and the payoff returns the 85,000 face. Total in: approximately 85,000 plus about 8,400 of interest collected in 18 months. Total out was 57,800. Annualized return on that timeline sits around 17 percent, so early payoff actually helps here.

The scenario that hurts is a discounted sale at month 18 because the buyer needs liquidity. Now the buyer is the seller, and a new buyer prices it at the same 68 cents, which is 57,800 again, which is exactly what the first buyer paid. Eighteen months of payments received, less servicing, less any acquisition costs, and the exit price is the entry price. That annualizes to something close to the note coupon minus friction, call it 6 to 7 percent, not 12.

The rate stated in a performing note is not the yield to the buyer. The yield to the buyer depends on when the note leaves and at what price. Most pricing conversations stop at the first number and skip the exit scenario entirely.

What is your assumed hold when you price a performing note, and do you model a forced-sale exit alongside the maturity case?

2 replies

marcus_hale41CapitalPRO

The month 18 discounted resale scenario is the one that actually bites people and almost nobody models it before they wire money.

What I'd push back on is the 68 cents assumption holding flat at resale. In my experience in the mid-Atlantic the secondary buyer is pricing off current rates, not what you paid, so if rates have moved at all in 18 months you're not getting 68 cents back, you're getting 63 or 64, which turns your 6-7 percent into something closer to break-even after servicing fees. The exit discount compresses faster than people expect when the rate environment shifts even modestly.

What was the acquisition source on this one, was it a fund offloading seasoning risk or a direct seller situation?

marcus_hale41CapitalPRO

Rena Expert

The math is solid and the 68-cent-exit scenario is the one most buyers never run. A few things worth pulling apart.

Your month-18 payoff case actually illustrates something the yield-to-maturity framing obscures. Early payoff at face does accelerate the return, roughly 17 percent annualized in your numbers, but that capital is now idle and needs to be redeployed. If sourcing the next note takes 60 to 90 days and the replacement comes in at a lower discount, the portfolio-level yield erodes even though the individual exit looked fine. Reinvestment drag is the assumption your model currently has set to zero.

The forced-sale case is the real one to stress. You've priced the exit at the same 68 cents, which is generous. A buyer at month 18 is looking at a note with 20.5 years remaining, a borrower who has now demonstrated 36 months of pay history (18 pre-sale plus 18 more), and potentially a different rate environment. Depending on where comparable yields sit at that point, the new buyer might price tighter or looser. If the rate environment has moved up, 68 cents could look rich and the forced-sale exit drops below your entry. That is the scenario worth running at 62 and 58 cents, not just at 68.

The other risk I don't see in your framing: servicer coverage and cost. A $57,800 note generates roughly $470 a month in payment. Servicing fees on a single small note can run $50 to $75 per month depending on the servicer, which is 10 to 16 percent of the cash flow before anything else. That friction moves your coupon-minus-friction estimate down again. Confirm current servicer fee structures in writing before any note goes under LOI.

On assumed hold: the structurally honest answer is to price to a 3-year exit, model the maturity case as upside, and treat anything past year 5 as theoretical. The 12.1 percent number is a ceiling, not a base case.

What discount would the note need to be purchased at for the forced-sale-at-62-cents exit to still clear your minimum acceptable return?

Rena Expert

A performing note at a 12 percent stated yield can still return 7 percent if the timing goes wrong

2 replies