Last month Lending Club conducted a webinar for their p2p investors that included the slide above. This was striking to me and gets at the heart of why I believe peer to peer lending is such a great investment today.
Like corporate bonds Lending Club notes are a fixed income investment. Also like corporate bonds there is a secondary market for Lending Club notes where you can buy and sell notes that have already been issued. But unlike corporate bonds, with Lending Club you get an interest payment and some principal repayment every month. Looking at the numbers above, if you want a similar return from bonds as Lending Club notes, you have to take on considerably more risk.
What the chart* above shows is a comparison of the risk/reward for corporate bonds and Lending Club notes. You can invest your money in a AAA-rated corporate bond and be rewarded with somewhere around 2% for a 5 year AAA bond (you can find the latest average yields here). There is very little chance of default, but there is also the risk that if inflation spikes in that time you will end up losing money in real terms and the value of your bonds will likely go down.
Higher Risk, Lower Reward
You can see that when you move down in bond quality the interest rate goes up but the default rate goes up higher, too. The high returns of junk bonds (those rated lower than BBB-) are offset by an increasingly higher default rate. You might think that a high yield bond mutual fund would be the best way to go. I invested in one of these funds for several years and the big problem here is that the value of your principal goes up and down. During the financial crisis some of these corporate bond funds lost 25% or more of their value.
The slide above makes the point that consumers with decent credit are a better risk than corporate America. That certainly appears to be the case for companies issuing junk bonds. But here is the real kicker. For individual investors, if you want to buy corporate bonds directly you often need to invest a $5,000 minimum. Many mutual funds also have high minimums. With Lending Club notes you can invest just $25.
As I said in my last post it is all about diversification. Should you put all your money in Lending Club notes? Of course not. But if you have a portion of your money in fixed income investments then you owe it to yourself to consider moving some of that money into peer to peer lending. Lending Club and Prosper both offer the fixed income investor a high return with less risk than high yield corporate bonds.
* One clarifying point about the chart above. The Net column is somewhat misleading. This is not a comparison of the actual net return of these various investments – the math will rarely work out that way. The Average Yield and Default columns are the more important numbers. Sources for this chart are: Lending Club for their return and default, Bloomberg for the BA Merrill Lynch current yields, and Moody’s for the long-term corporate annual default rate.