Investing in Peer Lending loans is becoming increasingly popular. Lending Club, the US market leader, has issued more than $3B in consumer credit, and there is now a frenzied competition amongst investors to snatch up the best loans.
In a previous article (seekingalpha.com/article/1677392-should-...), we compared Peer Lending returns with the Bonds market, and concluded that investing in Peer Lending, or at least in a large Peer Lending market such as Lending Club, can provide higher-returns than Bonds. We'll now review the fundamental differences between the two, and what they mean in term of risks. All the Peer Loans data come from the excellent Lending Club' statistics page (www.lendingclub.com/info/statistics.action)
While Bonds are used to raised multi-million dollars, Peer Loan amount are only a few thousands dollars, the Lending Club average being $13,380. Bonds are long-term loans, ranging usually from 10 to 30 years, although other debt securities such as Bills and Notes offer shorter terms (less than 1 year for Bills, 2 to 10 years for Notes). In comparison, Peer Loans have quite a short term. Since they're mostly consumer credit loans, they last only 3 or 5 years. Bonds are split up in 'trenches' of $1,000. Peer Loans are available in much smaller chunks, starting at $25. Bonds pay interests twice a year, and pay back the principal at maturity. Peer Loans pay back both interest and principal every months. They follow a principle of full amortizing, meaning the monthly payments are constant while the ratio payment of interest / re-payment of principal decreases over time.
|Bonds||Peer Loans (Lending Club)|
|Term||10 years and more||36 or 60 months|
|Loan Amount||Millions of Dollars||Thousands of Dollars|
|Payment||Interests twice a year, principal at maturity||Full amortizing|
The biggest risk when lending money is the inability or unwillingness of the borrower to pay back. Three approaches help in lowering that risk: credit scoring, guarantees, and diversification.
Bonds, usually issued by large companies or institutions, may come with some rating by agencies like Standard & Poor or Moody's. Some issuer may also benefit from a stellar reputation: loans from Microsoft or General Electric may look as safer bets. The prospects are muckier in Peer Lending. Lending Club and other platforms rely upon credit-scoring agencies, like FICO to estimate the lender's risk. However, the same amount of time cannot be spent analyzing a corporation borrowing $100M than an individual borrowing $5,000. Some of the essential data, such as monthly income, are self-declared and cannot be systematically verified. Moreover, the identify of the borrower is not disclosed; therefore investors cannot make enquiries beyond the data provided by the Peer Lending platform.
Since Peer Lending is mostly about consumer loans for the moment being, no guarantees are offered. This is the main reason why consumer credit interest rates are significantly higher than mortgage or car loans: there is no collateral to seize when the borrower stops paying. Here again, Bonds fare better since they can offer guarantees, for instance payment by a parent company, or against collateral assets such as a factory.
However, where Peer Loans have a stellar advantage is in diversification. While a Bond price is usually $1,000, an investor can put as little as $25 in a Lending Club loan. If $5,000 can only buy 5 different bonds, the same amount allows to invest in 200 different loans on Lending Club, providing a much greater diversification. It can be argued that the characteristics of Lending Club borrowers maybe too homogeneous to offer real diversification. However, data from historical loans show a remarkable diversity in geographic origins and demographics.
Interest Rate and Inflation Risks
Since investors would rather lend money at 7% than 5%, when interest rates increase, the value of existing bonds goes down. There is no such risk (almost) with Peer Loans, since investors tend to hold the loan until maturity. Another way to look at it is by calculating the Duration, or the length of time required to get the principal paid back. Since Peer loans have shorter terms and pay back the principal along the way, their Duration is much shorter than for Bonds, and they are, therefore, much less exposed to Interest Rate risk.
Likewise, the Inflation Risk, or risk the return of an investment doesn't keep up with inflation, is lower with Peer Loans than Bonds for the simple reason their duration is much shorter: money flows back sooner for re-investing. Which leads us to…
Or the risk of having to re-invest the money at a lower interest rate. Such a risk is much higher for Peer Lending, since a) money has to be re-invested sooner, b) it must be constantly re-invested, since payments are made on a monthly-basis. In comparison, because Bonds only pay interest before maturity, there is less to be re-invested. The absolute guarantee against re-investment risk is even a zero-coupon Bond, where no money at all is paid back before maturity.
Beyond the risk of lacking similar opportunities, a big drawback of Peer Lending resides in the necessity to constantly re-invest small amounts of money. Such a process is time-consuming, and quite demanding since the loans likely to provide the best returns are funded within a few seconds. [disclaimer: as a co-founder of www.LendingRobot.com, my views on the need to automate Lending Club investments may be skewed]
A Bond being paid back before maturity (or 'called') is, surprisingly, bad news for an investor, since it deprives him of future interests on the Bond, and because borrowers do it when the interest rates go down and it's possible for them to re-finance at lower costs. Therefore the investor is unlikely to re-invest his money at the same rate than the called bond. While it's possible for Bonds to provide some protection from this risk, by being non-callable for the entire term or some defined period (e.g. the first five years), no such options exist for Peer Loans.
As a matter of fact, early re-payment of Peer loans is quite common: 56% of the 14,122 fully-repaid loans issued before January 2011 on Lending Club were reimbursed in advance. Nevertheless, this risk is somewhat mitigated by the fact the repayments occur late in the loan life: on average, early repayment occur only in the 21st month (all loans in this dataset having 36 months terms).
Opportunity and Liquidity Risks
Because they have both higher payments and shorter maturity, Peer Loans have a lower Opportunity Cost (the fact that the invested money is not available for other investments) than Bonds. But Liquidity Risk, or the inability to get rid of an asset, is much higher in Peer Lending. Because each debenture is unique (even 2 loans from the same issuer have different amount, interest rate, issuance and maturity dates), Bonds and Peer Loans cannot be traded on a first market such as the NYSE. Debentures are traded on a case-by-case basis, or 'Over The Counter'.
Logically enough, the market for $11B of 5.15%, 10-year bonds from Verizon is much bigger, and therefore more liquid, than the one for John Smith's $12,000, 36 months loan. Although it's possible to exchange Lending Club loans on a secondary market, the process is lengthily, and quite tedious considering the amounts involved: while a Bond will still trade in the vicinity of its face value, a Peer Lending loan's value is only in the remaining payments. A $25 investment in a 36 months loan is probably worth less than $8 with 9 months remaining maturity, but negotiating its exchange price may take the same time than for a $1,000 bond.
Regulatory and Business Risks
The Bonds markets are very mature, ancient, even: debentures were traded as early as the 14th century, way before company stocks. In comparison, Peer Lending is ridiculously new, and exposed to much higher regulatory risks. However, the risk is more for the marketplaces than for the investors.
Peer Lending platform Prosper was temporarily shut down by the SEC in 2008, but that did not prevent lenders from getting paid. A bigger, business-related risk is a Peer Lending platform failing catastrophically, but that risk is hard to gauge.
Bonds have historically provided some sheltering from systematic risks, with a negative correlation between bonds and stocks in the long-term. However, changes in that correlation can be drastic, especially when interest rates are low.
Data is lacking for Peer Lending due to the young age of the industry, but we can take the S&P Experian Consumer Credit Default indices as proxy. These indices are a benchmark of consumer credit defaults in the US. If we compare them with the monthly returns of the S&P 500 for the last 5 years, we obtain a correlation coefficient very close to zero, at 0.014. At 0.28, the standard deviation of this correlation is also lower that the one for bonds, which is 0.4 on approximately the same period (source: PIMCO). It seems therefore that Consumer credit, and by extension Peer Lending, provides a non-hedging, but excellent diversification from Stocks.
Bonds can be made even more liquid when invested through an ETF, such as BND. In this case, buying and selling securities in almost trivial (provided the ETF is big enough). It also allows for better diversification, since an ETF like BND invests in more than 3,000 different bonds.
ETFs such as iShares' 1-3 Year Credit Bond (NYSEARCA:CSJ) even allows to invest in bonds with shorter terms than BND, and therefore more in line with Peer Lending durations.
Unfortunately, as of January 2013, there is no true Peer Lending ETF yet, and therefore no solution to invest in Peer Lending besides a direct subscription.
Is Peer Lending riskier than Bonds? Of course, and it does explain why the returns are significantly higher. But of all the risks mentioned above, the most important can be summarized as: the risk to loose money / not make as much money as possible. In this regards, and considering the affordable diversification, low correlation to the Stock Market and above-average returns, even after considering defaults, Peer Lending remain an attractive alternative asset.