Why I'm A Converted Believer In Investing In P2P Loans

by: Zack Miller

If you’re like millions of people, you’re probably worried about your net worth.

Pretty worried.

The market’s up and then, it’s down. Jobs are being created and lost. Banks are stable and then they lose $3 billion seemingly overnight. And politicians? Nobody seems to have a strong plan to get us through and certainly not the political will to see it through.

It’s not entirely clear if the economy is recovering or not.

Investments: Riskier, Less Diverse, Zero Confidence

If you have investments, you’re probably experiencing the following:

Volatility spikes: The market has the great ability to lull people into a false sense of security and then, wham! You get periods like the beginning of May where it feels like the world is ending. Nothing looks good right now. Nothing feels right, either.

Diversification doesn’t seem to be working: It may be exchange traded funds doing it or just a general move towards passive investing, but all types of investments are moving more in tandem. When stocks go down, they bring down other “safer” assets. The theory of diversification isn’t providing the benefits it promised. That’s where we are — when things are bad, it seems that there is nowhere to hide.

Lack of confidence in reaching financial goals: Many investors are just throwing up their hands. No más. They feel the stock market is rigged (it is, somewhat) and don’t want a part of it. But in an environment where bonds and CDs pay so little, underfunded-for-retirement investors need to reach for more risky assets and are forced to play a game that they don’t want to play.

What if I could tell you that you can triple the returns on the fixed income (bonds) part of your portfolio without taking on more risk?

Peer-to-Peer Lending: A Better Way

The more I speak with investors and entrepreneurs in online finance the more the topic of peer-to-peer lending comes up.

In peer-to-peer lending (p2p lending), borrowers post loans to a network of people who in turn issue small loans.

p2p lendingClick to enlarge

Now, before you scoff, I’ve spoken to really smart people. Risk managers, not gamblers. Some of these guys have hundreds of thousands of dollars in these platforms.

So, I began as a disbeliever (a p2p lending heretic, really) in all this stuff but frustrated with all the other investment options out there, I decided to do some more research.

Why Not Invest in Peer-to-Peer Loans?

A main beef against the peer to peer lenders is that it’s so hard to judge creditworthiness. True, it is hard but the tools are getting better to help investors judge their prospective investments in their peers.

Let’s see how well everyone’s playing with each other.

Objective look at default risk in bonds

First, let’s look at the historical default rate on investment grade and speculative grade (junk bonds) bonds. Things go in cycles and you can see the spikes during different markets.

Click to enlarge

Now, these are averages and the default rates vary widely depending on the credit rating of bonds.

Click to enlarge

You can see here how over the life of a bond, the risk for defaulting rises severely and then sort of plateaus. Interesting to not here, BBBs --still seen as investment grade -- approach an almost 10% default rate as they get closer to their maturity date. Time to pay the piper.

Now, let’s look at the data from one of the largest peer-to-peer lenders.

Click to enlarge

Source: http://www.prosper.com/welcome/marketplace.aspx

You can see the varying degrees of default rates and how the firm’s own credit rating impacts the default rate.

Below is a look of loans that were funded in the past year or so and what the estimated loss rate and return are.

Click to enlarge

Source: http://www.prosper.com/welcome/marketplace.aspx

From the table above, one thing I’ve noticed is that peer to peer lending firms -- and investors who use them -- are getting better at limiting losses.

Ha, S&P and Fitch are getting worse over time…

Risk and Returns: P2P Lending 1, Bonds 0

If you’re investing in junk bonds (where there is still a little yield), as time goes by, you have almost 50% chance of getting defaulted on. We haven’t seen, nor are seeing those numbers in the p2p loan market.

So, higher returns, lower defaults. That looks pretty good and may deserve to be a new asset class in your allocation or your clients’ allocations. Hopefully, we’ll get beyond the stigma of investing in this new product over the next few years.

What About Liquidity?

Another common quip I hear against p2p loans is their lack of liquidity. What if you want to sell?

One way to limit this is by really diversifying your investments around to numerous borrowers. Also, many of the large p2p loan marketplaces offer the ability to trade your notes (buy and sell). Check out Prosper’s deal with Folio Investing which trades notes through a registered broker/dealer (hint: there are chances to buy someone else’s note at a nice discount here, increasing your return).