The emergence of peer-to-peer lending has created a new investment opportunity for income-seeking investors willing to do a little extra homework.
The financial media mostly covers short-term opportunities. That applies mostly to stocks, but you’ll also hear about bonds that are “up” or “down” as their prices fluctuate each day. With the Federal Reserve keeping short-term interest rates so low for so long, the great fear is that market prices for bonds might crash as interest rates rise.
Bond prices must decline as rates go up, since newly issued bonds will pay higher rates. This can be painful for investors holding shares in bond funds: The share price will fall as rates rise, and there’s no guarantee that you’ll make up those losses when, years from now, rates fall again.
That’s why long-term investors seeking income might be better off holding their own paper. If you hold a bond until it matures, you know exactly how much of a loss or gain to expect. If you paid more than face value for it, and interest rates declined since it was issued, you can calculate the yield to its maturity and decide whether the income will be sufficient to outweigh the capital loss.
What does all this have to do with peer-to-peer lending? The answer is that it looks like an interesting option for income-seeking investors.
During this long period of low interest rates, income-seekers have been faced with a continuing problem: As their bonds have matured, they have had to either accept lower yields or more risk, taking on dividend stocks, real-estate investment trusts or business development companies.
Peer-to-peer is an alternative income source that could work out well for investors who take the time needed to understand the risks and rewards. If this sounds like you, read on.
How peer-to-peer lending works
Peer-to-peer lending allows you to make loans to individuals or participate in pools of loans, limiting your risk. You can use borrowers’ credit scores to decide how much credit risk to take.
The largest peer-to-peer player is LendingClub Corp. LC, -8.70% which began operations in 2007. The company originated $2.2 billion in loans during the third quarter, up 92% from a year earlier. Lending Club’s main competitor for peer-to-peer consumer lending is Prosper Marketplace, which didn’t respond to inquiries for this story.
At Lending Club, a person can borrow up to $35,000 with a fixed interest rate, for just about any purpose, with fixed monthly principal and interest payments. Business borrowers can have credit lines as high as $300,000. Many consumer borrowers are looking to consolidate and pay off credit card loans at a lower rate.
The loans have maturities of up to 60 months, and loan approval and interest rates are based on “stringent credit criteria designed to focus on the most creditworthy borrowers,” according to Lending Club.
The company said its average borrower had a FICO score of 699 and annual income of $74,414 as of Sept. 30. That income level puts the average borrower within the top 10% of U.S. earners. Loan applicants are graded A to G, with average interest rates ranging from 7.34% to 25.54%, as of Sept. 30.
Even that lowest rate, 7.34%, is attractive in this market — the average national rate for a five-year CD is 1.91%, according to Bankrate — though it’s not what an investor will receive. There are fees and, very likely, losses, since these are unsecured loans and lenders therefore have no claim to a borrower’s collateral.
If you lend to just one borrower, you could lose your entire investment. You can spread that risk by lending to many people at once: Lending Club lets you invest in “notes,” which are portions of loans, in increments as low as $25. So you might invest $2,500 by purchasing 100 $25 notes, effectively lending to 100 people. That’s quite a bit of diversification, and it limits your default risk to $25 per investor.
After you make your investment, you select your risk level and the number of notes. (For most investors, that should be at least 100, to lower risk through diversification.) Over time, the principal and interest payments will roll in, minus losses and fees.
Your investment will shrink as loans with relatively short maturities are paid down. The cash portion of your account will grow. You can set your account to automatically maintain your investment level, manage it manually or just let the cash accumulate.
Risk versus reward
Lending Club says virtually all — it says “99.9%” — of investors who own at least 100 notes of comparable size have seen positive returns. That’s good news: You’re unlikely to lose money if you spread it out among at least 100 notes.
Of course, income investors want more than just to avoid losses — especially since they need to account for fees and other costs. Lending Club charges a 1% servicing fee for all principal and interest payments that are collected on time; it doesn’t charge them for late payments, but collection fees can be significant. (We’ll discuss delinquency and collection charges later.)
This chart, provided by Lending Club, shows the average annual returns for loans, by credit grade:
The loan yields in this chart don’t match the ones in the first chart because this one shows the historical loan yields and adjusted returns, after credit losses and fees, for all Lending Club loans at least 18 months old as of Sept. 30.
Looking at seasoned loans that are at least 18 months old provides a reasonable idea of how many loans will go past due, and gives investors an idea of how much their returns will be lowered by defaults and collection fees. For example, for A-rated loans, the average annual return was 5.21%. That is significantly lower than the average interest rate of 7.72%, though still a good yield in this market.
The returns get higher, as does the volatility because of loan losses and fees, as the risk level goes up, until we get to loan grades “F” and “G,” which represent small groups of loans, according to Scott Sanborn, Lending Club’s chief operating and marketing officer.
The above loan-level chart still doesn’t show the actual return investors could have expected, but it gives a pretty good idea.
At the Investing tab at Lending Club’s website, they have posted an interactive chart that allows you to see median average annual returns for Lending Club note portfolios, while changing the number of notes, portfolio concentration and weighted average interest rates.
Here’s a sample portfolio of 100 notes, with no note making up more than 2.5% of the investment, with a weighted average interest rate from zero to 9%:
The median return for this portfolio, after loan servicing fees, collection fees and loan losses, has been 6.2%. The data supporting the chart includes all Lending Club loans going back to 2007.
It is impossible to make direct comparisons of the 6.2% portfolio yield to bond indexes, but the A-rated loan portfolio discussed above, seasoned at least 18 months, had a return (after all fees and losses) of 5.21%, which compares favorably to the BofA Merrill Lynch U.S. Corporates 2-5 Year BBB rated index, which has an average coupon of 4.78%, and a yield to maturity of 3.63%.
The BBB ratings are on the low end of what is usually considered “investment grade,” and the yield-to-maturity for the index is so low because the historically low interest rates in the U.S. have pushed bond prices so high. The yields are superior for even the highest-rated peer-to-peer loan portfolios at Lending Club.
What the investor gives up in return is liquidity. If you are in a hurry to get out of a peer-to-peer investment, you can try to sell your portfolio of notes to another investor, but there’s no guarantee Lending Club will find a buyer for you. It’s best to consider a commitment of at least five years, the maximum maturity for Lending Club’s consumer loans.
Credit risk and collection fees
We’re in a period of strong consumer credit quality in the U.S. For example, Bank of America’s net charge-off rate (the percentage of loans charged-off, less recoveries) for its managed credit card portfolio was 2.42% in November, compared with 3.66% two years earlier. A loss rate of 2.42% might seem high, but recall that credit card loans are unsecured.
During an economic down cycle, delinquency rates are likely to be significantly higher. Lending Club began making loans during 2007, right before the recession, but the majority of the loans making up the data supporting the return charts were made while the U.S. economy was on the upswing.
Still, it’s comforting to see that the average returns have been higher for loans with lower grades — the ones through grade “E” — despite the higher volatility caused by loan defaults and collection fees.
A Lending Club investor pays a 1% servicing fee for all principal and interest collected on their behalf. The fee is not charged if a loan is more than 15 days past due, but there are significant fees on overdue notes.
The normal collection fee is 35% of the amount recovered if “a collection action is taken” without involving litigation. (The company has lowered the regular collection fee to 18% temporarily, but warns this “may be discontinued at any time.”) If litigation is needed, the investor pays 30% of the attorney fees, plus costs. This means an investor could easily take a 100% loss, though no more, on a delinquent note.
”Lending Club does not charge a collection fee if no payments are collected, and no collection fee will be charged in excess of the amount recovered,” according to Lending Club.
Banks love the credit-card lending business because the yields are so high. But the loans are unsecured, so loss rates are fairly high. Peer-to-peer investments in loans are also unsecured, so you have to be comfortable with the knowledge that you will take losses. Ideally the yields, after losses and fees, make it worthwhile.
That, in sum, explains why it could pay for investors to embrace all the information a peer-to-peer lender provides about loan diversification and credit quality, settling carefully on a risk-to-reward strategy that makes up part of an income portfolio. It may also be a good idea to “start small,” and see how comfortable you are.
Nontraditional credit products expected to keep growing
There are other kinds of peer-to-peer investments. For example, professional money managers — including banks, insurance companies and private pension funds — are running limited partnerships that invest in Lending Club loans.
You can find more information on alternative investments at Lending Club’s website, or you can ask your broker or investment adviser for other alternatives.
Since Lending Club makes credit data for every single loan available for download, any investor can take their data analysis as far as they want. This is leading professional investors to form new businesses centered around the purchase of peer-to-peer loans or notes.
Lee Calfo, co-founder of Bluestone Capital Management of Philadelphia, with about $300 million in assets under management, believes peer-to-peer lending and other nontraditional credit products “will continue to take place of traditional lending over time.”
His flagship fund looks for limited partnerships built around such opportunities, including ones from Prosper and Lending Club.
The increased participation from professional investors offers a strong indication that peer-to-peer lending is here to stay. It’s not an investment that’s for everybody — far from it — but for those willing to take some control of their actions through a higher level of risk management, it could be a good source of income.
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