Why Short Term versus Long Term

When investing in first position notes, we favor short term versus long term instruments. These notes tend to offer a higher investment return. Why?

In order to illustrate this, we will use the example of “Understanding the Yield of Discounted Notes” from IRA Wealth by Patrick W. Rice:

To appreciate the benefit of discounted notes, it’s first necessary to understand that interest and yield are not always the same. Technically, the interest rate is the percentage used to determine the charge for borrowed money. The yield is the interest or return earned on an investment. Sometimes the yield is the same as the interest rate, and sometimes it’s not. To understand why, let’s look at a few notes and see how different variables affect the yield.

Let’s say that you buy a ten-year note that was originated by a bank. The note balance is $10,000, the interest rate is 10 percent, and payments of principal and interest will be made in monthly installments, which is typical of bank loans. Because such a note yields compound interest – interest not just on the principal but also on any unpaid accumulated interest – each monthly installment will be $132.15.

Therefore, if this note pays as agreed, over the life of the contract, you will receive your $10,000 investment back plus interest in the amount of $5,858. Your investment will be worth $15,858 at the end of the ten years – a yield of 10 percent each year.

Now let’s see what happens when the same note is purchased at a discount – for less than the current note balance of $10,000. Let’s say that the holder of the note is in need of immediate cash, and is willing to take less than the current balance to receive it. You offer and he accepts $8,000 for the note.

You are now going to receive ten years of monthly payments of $132.15, which will give you the same $15,858 as before. The difference is now, you will also receive $2,000 more than your original investment. So you will have a gain of $7,858 instead of $5,858. Your yield will now be 15.63 percent per year.

Now, let’s take it a step further. This time, you not only purchase the note for $8,000 but, for one reason or another, the borrower pays the note off early – say, at the end of the third year instead of the tenth year. So after receiving $132.15 monthly for three years, you receive the balance of the original note – $7,960.32 – $2,000 of which you did not pay for.

You are, in essence, receiving your $2,000 discount seven years earlier than expected. You now enjoy a 19.70 percent yield on the $8,000 you invested. Here’s another way to look at it: $5,960.32 is the principal return and the discounted $2,000 is the interest.

As you can see, the yield of an investment is determined by more than just the interest rate. Other variables include the price paid for the note, when and how the payments are made, and early payoffs. These factors can boost the yield above the interest rate, making the discounted note a truly outstanding IRA investment.