Note Yield Question

[Eduard Gibert Renart]

Hi All,

I want to get started buying notes and wanted to compare apple with apples. I have been running some hypothetical use cases and been comparing the returns with more traditional investment assets, and there must be something that I'm doing wrong because it doesn't add up for me.

Scenario 1 - 9.5% Yield vs Stock at 6%:

 5 year 12k note with 9.5% Yield, this means 60 payments of 252.02 for an end valance of $15,121.2 which gives me an annualized return of 4.73%. Now if I compare this to the stock market, for this case we start with 12k also but this time our investment give us a 6% return every year for 5 years. In this scenario the end balance is $16,058.71. Even thought the stock market gave us a 6% return it still outperformed the note by $937.51. 

Scenario 2 - 9.5% Yield (Multiple notes) vs Stock at 6%:

For this scenario we are going to use the same numbers as above the only difference we are going to be buying a new note with all of the money we get after ever year.

Year 0 - 12k to buy the note

Year 1 - We have 3024.24 (252.02 * 12)

Year 1 - We buy a second note 3024.24 at 9.5% for 4 years -- 48 payments of $75.98.

Year 2 - 3024.24 (1st note) + 911.76 (75.98 * 12 -- 2nd note)

Year 2 - We buy a third note 3936 at 9.5% for 3 years -- 36 payments of $126.08.

Year 3 - 3024.24 (1st note) + 911.76 ( 2nd note) + 1512.96 (126.08 * 12 -- 3rd note)

Year 3 - We buy a fourth note 5,448.96 at 9.5% for 2 years -- 24 payments of $250.19.

Year 4 - 3024.24 (1st note) + 911.76 ( 2nd note) + 1512.96 (3rd note) + 3002.28 (250.19 * 12 -- 4th note)

Year 4 - We buy a fifth note and final 8,451,24 at 9.5% for 1 year -- 12 payments of $741.03.

Year 5 - 3024.24 (1st note) + 911.76 ( 2nd note) + 1512.96 (3rd note) + 3002.28 (4th note) + 8,892.36 (741.03 * 12 -- 5th note).

Total: $17,343.6 

While this second scenario does outperform the 6% stock market return, it only give you a 7.64% annualized return while is better, if we implement scenario 2 in a self directed IRA where lets assume they charge you $150 every time you buy a new asset that would technically be $750 less of profit giving you a profit of $16,593.6 and a 6.7% annualized return.

I feel like my math is not correct or I'm missing something otherwise, can someone explain why even thought the note has a yield of 9.5% is performing slightly better than a 6% stock market return? How can I increase the annualize return? 

Thank you for the help

[Patrick Roberts]

Yield assumes that the cashflows are reinvested at the same rate of return and periodicity for the entirety of the life of the asset. In other words, a yield of 9.5% with monthly cashflows assumes those cashflows are reinvested at the same yield as soon as the cashflow is received. In your examples, you assumed holding the cashflows stagnant while the entire year of pmts accrues. In reality, as soon as your cashflow hits your bank account, it's either reinvested in a similar asset, swept to an interest bearing account (high yield savings account/CD), or reinvested in some other form. So in your example #2, pmt 1 of $252.02 would earn some kind of return for the remaining 11 months of that year until your put it to work in another note in the following year. The faster you put your money back to work, the more it will compound and the higher your annualized return will be. 

The variance in your CAGR returns is because the $12k in the note is returned to you in increments throughout the life of the asset, amortizing down to $0 at the end of year 5. The same amount invested in the securities market stays fully deployed for the entire term - in other words, all $12k of the principal (the basis) is at work for the entire 5 years. Once you make assumptions about redeploying your periodic note payments, such as the rate of return earned on the reinvested amounts and the periodicity, you'll see improvement in the CAGR for the note. As you get closer and closer to reinvesting your cashflows at 9.5% on a monthly basis, your CAGR will get closer and closer to your yield. 

[Chris Seveney]

@Eduard Gibert Renart

Because on a note you are getting principal and interest back and it’s hard to reinvest a very low payment.

What you are also missing is the tax consequences in these situations which can have major impacts

I did a post on this In tax liens advising where 8% is far better than 10% and illustrated this example.

[Eduard Gibert Renart]

@Patrick Roberts thank you for the detailed explanation, now it makes total sense. Any recommendations for reinvesting right away small amounts of money when you are doing this on a self directed IRA?

[Eduard Gibert Renart]

@Chris Seveney do you mind sharing the link to your post? Thank you.

[Patrick Roberts]

Quote from @Eduard Gibert Renart:

@Patrick Roberts thank you for the detailed explanation, now it makes total sense. Any recommendations for reinvesting right away small amounts of money when you are doing this on a self directed IRA?

 As @Chris Seveney was saying, it's hard to reinvest small payments like that. Base case would be to sweep to a money market fund or some kind of cash fund where the payments can earn interest until you accumulate enough to reinvest into a new note. Most MM accounts are yielding 4-5% right now. You could try to find more aggressive fixed income funds or ETFs, but transaction costs and market volatility could make your life difficult. Chris's fund may be an opportunity for you if you want to invest in notes, also. 

[Ivan Terrero]

@Chris Seveney

Can you please repost this?

Thanks!

[Eduard Gibert Renart]

@Ivan Terrero I think I found the post @Chris Seveney mentioned. 

https://www.biggerpockets.com/forums/70/topics/1170394-when-...

[Ivan Terrero]

Quote from @Eduard Gibert Renart:

@Ivan Terrero I think I found the post @Chris Seveney mentioned. 

https://www.biggerpockets.com/forums/70/topics/1170394-when-...

 THANKS!

[Marco Bario]

@Eduard Gibert Renart - Interest-only notes would produce a consistent yield.

Another strategy is to buy discounted notes. The goal is to buy a whole note at a high discounted yield, then recapitalize by selling the whole note or a partial at a lower yield or borrowing against the note at a lower yield. 

Jimmy Napier used to teach about the "Deal after the deal." Peter Fortunato teaches that "Closings are beginnings." 

It's fun putting together and executing these longer-range strategies, and one can create incredible wealth-building strategies.