I discussed the concept of Loan Notes in an earlier post titled "Exploring Loan Notes as an Alternative Investment". In this post we will go in more detail at just how risky loan notes may be and potential strategies or actions that can be taken to reduce these risks.
What risks to consider?
Like any investment, there is always some risk associated with loan note investments. The aim is to be aware of these risks and to minimise any one of them or to be comfortable with the level of risk and to minimise any potential losses in the event the risk turns into reality.
Risk of borrower default
Investing in loan notes means you are taking on credit risk—the risk that the borrower will default on the loan, or that the lender will not pay out the principal amount when the loan matures.
The amount of risk is dependent on several factors, such as the creditworthiness of the borrower and lender, and whether or not there is collateral involved in securing the loan agreement.
Market Risk
There is also market risk associated with these types of investments; if market conditions change significantly enough during the course of your investment, it could affect your interest payments and in the worst case the return of your initial investment.
How can you minimize risks from investing in Loan Notes?
Investing in loan notes comes with some inherent risks; however there are steps investors can take to mitigate these risks and maximize potential returns from their investment. First and foremost investors should always aim to preserve their capital.
Consider the different types of Loan Notes carefully
One way you can mitigate or minimise the risk is by carefully choosing the type of loan notes that you invest in. There are typically 3 types that are available.
Secured
A secured loan note is backed by collateral in the form of borrower's assets. This gives you a legal claim to the assets of the borrower should they default on their loan obligations.
Traded
Some loan notes use company stock as collateral for loan notes in the case of default. This gives the lender security that they can claim shares in the company should they default on the terms of the loan note.
Unsecured
As the term suggests, there is no obligation or security given by the borrower to the lender that to repay the capital should the business not be able to meets its obligations. This is also less common impactive and relies on a good deal of trust between the parties.
Convertible
Convertible loan notes are generally used when a business needs rapid access to cash. These types of loan notes can be converted into shares by the lender after certain conditions are met or after a predetermined period of time. This type of agreement requires considerable discussion to come to a clear understanding of the conditions by both parties.
Due Diligence
Doing research on potential borrowers before committing funds is extremely important. You must understand their credit history and reputation before investing in them so that you know that they can continue to meet their obligations to you in the future.
Check the paperwork
Additionally, it’s important to make sure that all legal paperwork related to the loan is properly executed so that both parties understand the terms and conditions surrounding repayment schedules and interest rates should anything happen during the course of repayment (such as bankruptcy).
Diversify your portfolio
It is always wise for investors to diversify their portfolios by investing in multiple borrowers rather than putting all eggs into one basket. In doing so if one borrower defaults on repayments then not all funds will be lost at once!
Conclusion
Investing in loan notes can be an attractive alternative for those looking for higher yields than more traditional securities like stocks or bonds while still minimizing their exposure to significant losses due to defaults or market volatility. By assessing the risks and performing detailed research into the companies offering Loan Note investments before committing funds you considerably increase your chances of earning above average returns while minimising the downside risk of losing your employed capital.
Spreading out your money across multiple transactions rather than one large one, investors can further reduce their overall risk!
If you are interested in finding out about other options for diversifying your portfolio and the risks associated then consider reading our blog post "How to Diversify Your Portfolio with Alternative Investment Opportunities"