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

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.

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.