Investing in debt has long been practiced by many smart investors - those who are risk averse and others willing to accept some degree of risk for a correspondingly higher expected rate of return. (For assistance in achieving high returns, check out Disciplined Strategy Key To High Returns.)
TUTORIAL: Investing 101
By mid-August, 2011, U.S. government debt had been downgraded by Standard & Poor's ratings service from a no-risk triple-A rating to an AA+ rating, one step below, but certainly not indicating a major risk that the U.S. would default on its debt.
At the same time, the U.S. debt ceiling had been raised by an agreement with the Obama administration and the U.S. Congress and Fed Chairman Ben Bernanke promised to keep U.S. Treasuries at their same low interest rate - nearly 0% return - for the next two years. With those factors in mind, many investors looked for alternative or non-traditional debt to invest in.
Some of these debt instruments are: consumer loans, micro loans, factoring, direct real estate loans and mortgage backed securities.
Each of these debt instruments functions differently, their returns vary and the degree of risk is different for each. Junk bonds, basically high-risk debt, once a popular way to speculate rather than invest, will not be considered in this article because of their volatility, unpredictability and risk.
There are several major companies that make consumer loans and give investors an opportunity to invest in these loans. Investor cash provides the capital these firms need to provide funding for the loans they grant.
A leading firm in this category is Lending Club, with an online platform enabling investment in their debt. Loans are made according to strict criteria and less than 10% of loan applicants are approved, according to information from Lending Club. The average Lending Club borrower in August 2011 has a low 13% debt-to-income ratio, excluding mortgage, and a personal income of $96,500, at the top 10% of the U.S. population.
The firm has lent more than $333,000,000 as of August 2011, money provided by investors.
Depending on a system of grading risk, Lending Club loans have returned from 6.04% to 12.11% in August 2011.
Investors may also put money into so-called micro loans, which are small loans that can start as low as $100 and range upwards to several thousands. Borrowers are typically small business owners or entrepreneurs in developing countries, who are sometimes not qualified or considered sufficiently creditworthy to obtain traditional loans from banks or other lenders. A number of micro lenders have a presence on the Internet, some of which attract investors who want to do social good because of lending policies favorable to low-income borrowers. Among these firms are MicroPlace.com, and Kiva.org, a non-profit. Kiva says its loan repayment rate is 98.8% as of 2011. So investors in the debt of this organization are exposed to a relatively low 1.2% rate of default. (For more on these types of products, read Microfinance: What It Is And How To Get Involved.)
Factors are buyers of a firm's accounts receivable at a discount to the amount owed. Depending on the creditworthiness of the debtor, a factor may pay the seller from 60 to 80% of the amount owed. The factor will then attempt to collect the entire amount receivable from the original debtor. By investing in factoring firms, investors would be investing in debt that's owed to the secondary creditor.
Direct Real Estate Loans
Real estate owners of commercial and residential buildings, and land may consider financing the purchase of their property directly. Rather than seeking traditional financing through a mortgage, the seller would carry a note or mortgage, and perhaps retain title to the property until the debt had been entirely paid. There may be benefits in this arrangement for both buyer and seller. For the buyer, credit terms may be less stringent than what a bank would require. For example, the buyer may be able to negotiate a smaller down payment and lower interest. Benefits for the seller may include retention of the property title, and steady cash flow. Both participants in this form of transaction are advised to retain an attorney to represent their interests when drafting a contract.
Some investors may be justifiably reluctant to consider investing in mortgage-backed securities because many such packages of debt sold by private financial firms failed to perform and contributed to the economic crisis that began in 2008. But the U.S. Treasury Department is selling mortgage-backed securities, in this instance guaranteed by either Fannie Mae or Freddie Mac. Some $10 billion of these securities will be sold every month through State Street Global Advisers, acting on behalf of the Treasury Department. Yields are low, but guaranteed.
Investing in debt may seem like an esoteric idea, but it's really a common financial option. Government and corporate bonds, mortgages and loans made to businesses or to individuals are all forms of debt that attract investors. The several non-traditional ways to invest in debt provide an alternative for investors seeking other opportunities.
But the individual investor should note - a long-established rule advocated by prudent financial advisers is to limit investments in any one sector to no more than 4% of your total investment portfolio. That way if there's a default, or a suspension of interest payments, financial damage to your portfolio will be minimal. (For other types of fixed income, check out How To Create A Modern Fixed-Income Portfolio.)