I’m often surprised how many investors take no notice of what is securing their money (aka collateral), when they happily lend their life savings out to any Tom, Dick or Mary investment fund in the form of a Bond, term deposit or fixed income financial product.
Collateral is insurance for Bonds
For me, security is insurance, and as a Fund Manager, this is the most important factor in all the considerations I work through when assessing an investment for our own asset backed fund at OTG Capital.
Collateral is what you get back in case your borrower doesn’t pay back the cash they promised to pay you when you loaned them the money in the first place.
Remember a bond is simply a loan. You are the provider of funds to an investment trust, bank, corporation, property developer or similar - and collateral (or security) is what takes the place of your money if the borrower doesn’t pay you back.
Secured / Un-Secured – What’s the Difference?
Rather simple really - a secured loan or bond is something that has collateral, and an un-secured loan does not. It will therefore come as no surprise throughout the entire lending market the difference in interest rates for those who borrow against a security or asset in deference to those who don’t (if they’re able to get finance at all!)
But not all collateral is created equal
Tip 1 – Make Sure It’s Real
There are many painful stories of phantom houses, blocks of land that didn’t exist, “good will”, intellectual property or trademarks that aren’t actually owned or really worth anything transferable to cash.
If you’re not sure, do a drive by, check the house is really there, do some desktop research with satellite images. Don’t forget to have an independent valuation done to verify and validate the security’s true worth.
Don’t take the borrower’s word
Tip 2 – Future Worth Doesn’t Count Today
Collateral that has future value is not real collateral. If a block of land is valued at $200k but will be valued at $600k when the sub-division approval comes through, that’s wonderful!
But for mine, the value is still $200k until the actual sub-division happens. Any number of things can happen before this event is realised. And, should that approval not happen for any range of valid reasons, you can’t bank or cash in future value today when it comes to the crunch.
Same applies for these familiar statements:
- “imminent market breakthroughs are just around the corner”
- “a huge 10-year procurement contract is due next month”,
- “pending FDA approval for this wonder drug”, or
- “when we strike the gold seam”
Tip 3 – OLV
OLV = Orderly Liquidated Value, this is not a term you’ll commonly find in the investing lexicon, but it is one that I strongly ascribe to. Time is a crucial factor when having to sell any asset, and in particular if that asset is for any reason distressed. Therefore, we need to also evaluate what is the value of something if you have to sell it quickly (and I don’t mean “fire sale”).
In real estate terms, we usually discuss a 3-6 months period to move a property as reasonable and it confidently doesn’t give the market messages of desperation. OLV also abides by the long-held rule of real estate valuation – location, location, location.
The worst house in the best location will always sell quicker than the best house in the worst location.
And consider this if you are being offered a company car, computers or business equipment as collateral for a loan. What is the real value (OLV) if you have to sell it? Will you really get all your money back, or possibly just pennies in the dollar.
A quick check on eBay or Gumtree or similar buy/sell/swap sites will let you know the true worth of a computer, office furniture or a company car. The results often shock and disappoint if you’re the one in a bind trying to get your money back.
Tip 4 – Make Sure They Own It
Very much tied to Tip 1, is the collateral real - if a house is being used as collateral, a title search will reveal all you need to know. The owner/s and any encumbrances or caveats on the property are fully spelled out – which is then also tied to Tip 6 – Head Space.
Also, make sure the borrower has the right to use the property as security, especially if the title is in joint names – both title owners have to agree. Same goes for cars, a quick check of the government vehicle register will save many tears later on.
Tip 5 – Validate/Verify for yourself and have a Process
Most people hate contracts as they are the document of last resort when matters go pear-shaped. But my job entails reading them, understanding them and abiding by them.
Loans, investment bonds, term deposits, PDSs, IMs are all contracts that provide an investment vehicle for you in which you loan money to someone else, and they pay you back with interest.
contracts protect both borrower and lender
I strongly recommend you develop and master your own validation /
verification process that enables you to ask the right questions and get the
answers you need without having to have awkward discussions that start with the
other side asking – “Why do you need to check?” or “Don’t
you trust me?"
Having a process in place avoids that
awkward question every time
You don’t have to question the borrower’s honesty because you’re simply adhering to a proven, long used process, and there are no exceptions.
There’s no excuse for you not to verify and validate that their collateral is real, can be changed for cash in a reasonable time frame, and is actually owned by the borrower and really worth what they say.
Tip 6 – Head Space
Just covering an outstanding loan for its full value is never enough. Having room at the top for additional considerations like legal costs, delays in completion, penalty payments and a safety buffer should the market turn against you is a considered, wise posture to take.
You’ll often see this “head space” quoted or referred to as LVR – loan to value ratio. As an example, if you are lending on a 70% LVR, that provides 30% head space should something go wrong, or interest payments take longer than you anticipated.
Peace of Mind
Having collateral or security significantly increases the safety of your investment in bonds. While not all collateral is created equal, we hope our quick reference tips will assist you in ensuring your “insurance” is a real plan B should something not go to plan.
Bonds are as safe or dangerous as you make them, having good quality security ensures you won’t get burned even if the market turns against you and your borrowers.
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