Can net returns be positive even in case default rate is above the interest rate?

Net returns on a portfolio can be substantial even if cumulative default rate is equal or even above the nominal interest rate. This is because the performing portfolio continues to generate interest and repayments over the full cycle of the loan not only in a single year.

Over an average 52 month cycle the performing loans and parts of the non-performing loans generate and pay interest for 52 months. Therefore in case one would want to compare this number with the cumulative default rate then the nominal rate should either be cumulated as well or the default rate annualized over the 52 month period. In the calculation model shared above we have built cash flows for an imaginative portfolio with 10% nominal interest rate and a 12% cumulative default rate to illustrate this.

We have seen some investors build analyses where portfolio returns have been calculated as interest rate less cumulative default rate (or cumulative expected loss). Furthermore some of these analysis have been done by calculating tax income on the nominal interest rate although non-performing loans do not pay interest and hence are not taxed. Such models unfortunately are misleading at best due to the reasons explained above.

Please make sure you use the full cash flows when building your own portfolio evaluation models and apply taxation only to actual paid interest not nominal values.

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