P2P lending looks less than attractive on a forward-looking basis

By David Stevenson on 1st August 2017

P2P/Marketplace Lending

One of the great investment stories of our age is the scramble for yield. For the first few years, this immense global trade pretty much passed me by. I’m one of those good old fashioned equity investor types who focuses pretty much exclusively in my own portfolio on long term capital growth although I will buy the odd bargain bond or income opportunity.

P2P lending looks less than attractive on a forward-looking basis

But I sometimes sense that I’m a slightly dying breed, surrounded by a great army of fifty and sixty something investors who are insistent on an income yield. It seems to me that a large slug of money is currently sloshing around the global markets in search of any income yield much above 3%. Crucially, as a direct consequence of central bank actions, this money is being forced to hunt down all manner of alternative income sources. And I would suggest that this imperative shows no sign of slackening anytime soon.

The logic behind this scramble for yield is obvious and rational. If the manager of a sensibly structured fixed income fund struggles to get a blended average yield of much above 3% then what do we expect investors to do? Sit tight or scramble for yield. The answer is obvious. Scramble!

But as these investors scramble away from frankly pitiful bond yields they bring with them a fixed income mentality. This involves two major components:

  1. A backwards looking view of yields based on the fact that historic volatility for stuff like bonds is actually fairly low. Defaults also don’t vary by a huge amount over a cycle, although that, of course, depends hugely on the fixed income niche you focus on.
  2. They also bring with them a hierarchy of yield expectations. Put simply anything yielding less than 4.5% is regarded with some suspicion, whilst the sweet spot is probably between 4.5% to 6%. This band gives investors a taste of more typical long term returns derived from investing in riskier assets. Anything too much above 7% by contrast probably strikes them as a bit too risky.

Which brings me nicely to P2P lending. As my colleagues at AltFi Data observe more and more money keeps finding its way into the industry even though some platforms have started to experience a marked slowdown in inflows. Overall though the sector I would say is in good health.

But, and yes, there is an important caveat, I am beginning to sense an important tipping point. Returns of between 4 and 6% pa from the big platforms – with an emphasis on the lower range of that spectrum – haven’t changed too much (in fact they’ve slightly fallen back). But I’m increasingly thinking that these returns are now inadequate for the potential of increased risk.

To go back to my earlier comments, my sense is that many investor’s look at P2P lending as an outgrowth of traditional fixed income spectrum – almost “very alternative” fixed income or credit. But it isn’t. The clue is in the title. It’s lending. And lending analysis is different and unique.

Cynical lending experts always assume the worst and expect every borrower to default. They’re not trained to believe that every borrower is honest, unlike bond investors. Quite the contrary in fact – they’re trained to expect defaults, to expect delinquencies, to spot the crook, and the serial boaster. In sum, they are pleasantly surprised when most borrowers turn out to be honest.

If one comes from a lending POV (point of view) then I would argue that the current returns are woefully inadequate, given where we are in the lending cycle. I’m not going to labour the point but I’ll list some canaries currently chirping away at the filthy coal face of mass market lending:

  • The big banks are starting to increase their provisioning for bad debts
  • Here in the UK we’ve probably reached Peak Unsecured Lending with the BoE bearing down on all lenders about risk, worried senseless about a downturn in consumer spending as Brexit grinds on
  • The car lending market is quite clearly close to a systemic meltdown
  • ‘challenges’ are already appearing within the P2P space, most recently at Ratesetter where its wholesale lending capacity is being wound down
  • The housing market looks more vulnerable than ever before, with the very real possibility that we’ll see a steady drip feed of small price declines

On a backwards looking basis, of course, beloved of most traditional fixed income types, everything looks rosy. Defaults are low, and I’d expect developed world interest rates to remain low for the foreseeable future as well. But if you’re a hard nosed lending analyst, it all looks a bit scary.

Which brings me to the current rates of return on offer. The market is currently pricing in a relatively benign lending environment, which is in turn priced into the lending rates. Zopa and Ratesetter have to compete with big banks which lend at ridiculously low rates on unsecured loans. Thus, the yields on offer for investors.

But if we are due a nasty, downwards TrumpBump, as well as a rise in lending losses of the order of 2 to 3 times current default rates, then the current rates of between 4 and 6% are simply not enough. On a forward looking basis I’d require a minimum return of 5 to 7% to compensate me for the potential for likely losses over the next year or so. If I don’t get that I’ll simply stick with more boring government bonds (offering maybe 2% at a push at longer durations) or maybe I might just sit tight with my cash.

P2P lending platforms are of course not hard wired to look at lending in this way. They are dynamic market places where largely ‘dumb’ capital (and I mean that in the nicest possible way) looks to find any sensible yield to compensate them for the declining real value of their cash. This capital doesn’t sit there worrying about lending dynamics nor does it ‘demand’ a new risk adjusted yield especially when high street savings rates are still at all time historic lows. It is classically within a market framework backwards looking. But smart investors in lending need to be forward looking. You need to think the worst every day and then be appropriately rewarded for the risk. And on this basis, current rates are inadequate.


Brian Holt

07 Aug 2017 03:12pm

A pretty pessimistic view! I've been a P2P lender for about 5 years and across a number of platforms my weighted average return, after fees and losses, is 7.5%; way better than your suggested 4-6 range. I do the usual investment things; only invest in industry sectors I understand, spread my risk, etc. I get frustrated at mainstream financial commentators (see this weekend's Sunday Times for example) who constantly paint a picture of P2P being too high risk. I may in future be proved hopelessly optimistic and myopic in my views, but so far P2P has consistently given me a better return than any other form of investment.

Bob Johnson

04 Aug 2017 12:00pm

Stress does seem to be present in the Ratesetter rolling market as last month the average rate was under 3% and now it has shot up to 3.7% very soon after they announced their wholesale exposure. I am monitoring the situation closely as Ratesetter depend on liquidity to keep the rolling market functioning.


04 Aug 2017 10:18am

Even with defaults in the p2p consumer space rising, you still are way above most sensible bond yields. Half the 6% rate to 3% and it's still reasonable for the risk. I agree with the comments above btw but perhaps the assumptions on negative consumer credit need to be tempered a little.

David Stevenson

02 Aug 2017 05:43pm

Hi Stuart. Put simply, I agree. I also think that secured lending does offer more protection at this point in the cycle but it's not a safe haven against all eventualities. Take auto lending which is secured but I think will be a lousy investment for many. Asset depreciation and delinquencies will increase. Where I think the real opportunity is in when the big banks start drastically re pricing risk - and then drastically increase interest rates. They'll be blunt and misprice risk for some businesses, for instance, opening up the real opportunity. To use an analogy from the world of investing, the big money will be made not by passive chasing the main market beta but picking the right loans using alpha credit technologies which gives the investor a risk adjusted extra return. Banks and other lenders will over react and therein will be their mistake.

Stuart Law - Assetz Capital

02 Aug 2017 07:40am

Very shrewd analysis David, and calling the inflection point well I feel. Regardless of any minor base rate rises that may come in the next year (a mistake in my view) it does appear that default rates in consumer debt seem to be already rising. Some of the more switched on P2P investors are tracking this and showing concern when reading their charts. The forums are where these canaries live. It's clear to see some raised rate expectations as a result or even some exiting to other asset classes so perhaps the most savvy of the 'dumb money' as you say has already worked out what you have too. Nonetheless I think that provided the borrower market can afford the right rates we will see several platforms offering the target returns you indicate - the exception may be 'prime' consumer debt where competing with high street 3% rates must surely become impossible for P2P shortly and push lending up the credit risk curve. Secured lending has the feel of a more secure haven - provided amortisation is a major component of the lending to at least keep up with any possible security value falls in coming years. Overall I am optimistic but it is certainly time to be tightening up credit quality a little across the board and / or raising rates a little. We have started the former and are reviewing any requirement for the latter. Overall I do feel that those platforms (and their lenders) that have got their credit and default management right, operate in the markets one step back from high street banks, have decent security and / or borrower quality, treat their lenders well and offer rates as you suggest will do well through what may become a real-time stress test. Interesting times indeed.

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