For many people, it’s a surprise to learn that with promissory notes, what you see is not what you get. We are used to relying on government- or bank-backed notes; for example, when you have a $100 bill in your wallet, you have the full promise of the United States government that you can purchase $100 worth of goods or services. Alternately, if you have a certificate of deposit from a bank, you trust that you will be able to redeem it for the full face value. However, with promissory notes, the value of the note is only backed by a private individual, or potentially the mortgage or equity of real estate, and that uncertainty, known as repayment risk, is what depreciates the value of the note. By selling the note for less than its face value, the yield is increased, which helps offset the increased risk of nonpayment.
There are a few other factors that influence the discounting of private notes:
1. There is no public promissory note market
Most financial assets have a physical or electronic public marketplace, where potential investors may buy and sell in a public forum. Most people are familiar with these markets; for example, the New York Stock Exchange and smaller stock exchanges across the world, gold and silver markets, cattle markets, bond markets, and so forth. However, there is no analogue for the promissory note market. All transactions are handled and negotiated privately between individuals, with the exact results of the transaction, and the price paid, kept between them and not shared publicly.
2. The number of note investors is very small
Unlike the stock market, which has millions of investors, the market for note investors is statistically nearly insignificant. Most people would prefer to have cash in hand than a piece of paper promising to pay you some agreed upon value at some point in the future.
Those who invest in notes are the latter type of people: they realize that the note is a promise to pay you that amount, plus interest, in the future. The risk, of course, comes with the fact that the person may not be able to pay you, and you will have lost money. Statistically, note investors comprise less than 1% of potential investors, leaving you with a very small investor market.
Because the market is so small, and investors may be spread out across multiple states, transactions take a long time to complete. Unlike the instant transactions found on the NYSE, promissory note transactions make take days, weeks, or even months to complete in their entirety. Because of the slow transaction time and small market, investors must often sell the notes at a discount to entice buyers.
3. No two promissory notes are the same
Unlike publicly traded stock, which is more or less the same (or at least stock from the same company will be the same), no two promissory notes will ever be identical because they were originally drafted to fit a specific need. For example, the note might have been written as part of a divorce agreement, as a gift, as part of a partnership liquidation agreement, or as a mortgage note, just to name a few examples, and all of these notes will have their own terms, language, and conditions. Because of this diversity, it requires time and expertise to read and understand each individual note, contributing to the exclusivity of the promissory note investor market.
In conclusion, promissory notes are discounted to reflect the associated risks of investing in notes. The main reasons for this are- no public note market- investor pool is small- no two notes are identicalBecause of this, many of the notes in the system are falsely priced and unrealistically valued. This article touched on the main reasons for the devaluation of notes, but there are many potential reasons. In a subsequent article, we will explore these other reasons more in depth.