Remain consistent with your risk tolerance
The most important aspect of investing should occur before you buy anything. Before investing in a loan or committing to the Portfolio Manager tool, you should first determine your risk tolerance. After that, it is important to make sure that your investment activities are consistent with the investment strategy/risk tolerance you have set for yourself.
The Secondary Market offers many opportunities for investing. However, you should also keep a cautious attitude; many of the borrowers in this marketplace exhibit a higher risk than the loans that would be seen in the Primary Market. Investing strategies differ but all wise investors keep their portfolios diversified. Investing in Secondary Market should also follow that principle.
Cash flows may be irregular for Secondary Market loans
Some investors use a strategy of seeking discounted overdue or defaulted loans that are still receiving payments. For example, if you buy a 100€ loan with 50% discount, you only spend 50€ for the 100€ principal. These loans may offer good earning opportunities and are attractive to investors.
However, in many cases these payments are made according to the agreements within the collection and recovery process and may not adhere to the original payment schedule. This means that an inherent higher risk is involved because these payments may not be regular and the principal bought may not be recovered to full extent. While the discounts and potential returns are higher on these riskier loans, investors must remember that the eventual returns are dependent on the collection and recovery efforts. This year we have put in a lot of effort to improve the collection and recovery efforts across all countries and as a result we are seeing roughly a 2/3 overall principal recovery rate.
Understanding the cost of premiums
Current loans are attractive to those interested in keeping their portfolio risk profile more conservative. In fact, some investors will pay a small premium for a loan belonging to a low risk borrower with no previous payment problems. Still, in these cases it’s important to evaluate two aspects:
- if the expected cash flow generates more than the cost.
- if the expected returns after the premium cost align with expected return of the whole portfolio. Or in other words, the returns are proportionate to the risks taken.
Sometimes though, the premium of the loan bought from Secondary Market is too high and it eats up the potential returns so that the eventual returns are far lower than that of the average portfolio returns.
Understanding opportunity costs
There are no fees for investors and the potential earnings on the Secondary Market can be attractive. However, you should always consider the the opportunity cost aspect when investing – instead of buying loans from Secondary Market with a markup, you should evaluate if it is more reasonable to place your funds into Primary Market loans which have no premium attached and mostly hold a lower risk.