Loan participations have become an increasingly important tool for credit unions, allowing them to manage their balance sheets and generate additional income. Naturally, when parties are conducting a participation sale, the sale often hinges upon the estimated yield for the participation.
However, estimating the yield of a participation is not a simple task even after accounting for the participation’s price, servicing spread and the assumed average prepayment speed for the underlying loans. Other more subtle factors, which are frequently overlooked, often materially affect a participation’s yield and cause it to diverge from the basic characteristics of the underlying loans. Two factors that drive this divergence are:
- Accrued Interest: A loan participation frequently is purchased after a loan has closed, sometimes months after, and therefore the seller is entitled to accrued interest
- Delay Days: While loan-level cashflows are collected and distributed to the originator on the actual payment date, there is a delay between the date that the loan pays and the date that the originator distributes funds to participation holders
Incorrect treatment of either of these can lead to erroneous yield calculations. The effect of Delay Days is typically greater so for purposes of this article, we will focus on how Delay Days impacts expected yield.
The Impact of Delay Days on Expected Yield
Delay Days result in an extension of the average life without any off-setting additional interest; participation holders wait longer for their money but do not earn interest during the additional time. The magnitude of the yield change due to Delay Days is a function of both the amount of the delay and the weighted average life (WAL) of the participation.
The following table illustrates the impact of the Delay Days on yield. The table varies both the Delay Days and the term of the loan. For simplicity we have analyzed a 6% interest-bearing bullet loan that pays interest monthly on the 15th day of the month. We have also excluded prepayments which makes the term the same as the WAL.
As can be seen, for very short loans, the detrimental yield impact is very large, materially reducing a participation yield relative to its loan yield. However, even for a 2-year loan (roughly the average life of an auto loan), Delay Days can reduce expected yield by 14-24 bps.
The Better Way to Calculate Expected Yield
A better way to measure yield for participations, and one that conforms to NCUA guidance would be to take the expected cashflows and do an internal-rate of return (IRR) calculation using the expected purchase and cashflow dates, purchase price (including accrued interest) and projected future cashflows. This can be done using participation analytics packages as well as within Excel using the XIRR function. Even better is to take these calculations one step further and convert the result into a semi-annual bond-equivalent yield, which would then allow apple-to-apple comparisons with how other fixed-income instruments and benchmark yields are typically quoted.
Better Technology Equals Better Yield
While it is important to correct for Delay Days when calculating the expected yield of a participation, simply put, better technology for reporting and remitting payments can reduce the impact of Delay Days. As informed buyers seek to achieve certain yield targets, longer Delay Days ultimately cost the seller in the form of a lower price and therefore less proceeds. The faster a selling credit union can complete and remit monthly payments, the shorter the Delay Days and the lesser the impact. Conversely, participations from sellers that are operationally unable to reduce Delay Days will experience greater yield leakage, and buyers anticipating such should not be willing to pay as high an upfront price as the expected yield will be less for the same loans.
This article was written by Ian Lampl, CEO of LoanStreet, and Eric Marcus, Head of Trading, for CUinsight.com. The original article was published on March 11, 2021.