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What Will Happen To Returns When Interest Rates Rise?

by Peter Renton on April 26, 2013

In a few months it will be five years since the Federal Reserve lowered interest rates to zero. I don’t think anyone could have predicted rates would be this low for so long. While the stock market has been hitting new highs recently the rates for fixed income investments have remained at historic lows. People looking for income producing investments have had few options.

It is against this backdrop that p2p lending has come of age. It is relatively easy to sell investors on the idea of 8-10% returns when there are so few options for returns like this elsewhere. But what happens when interest rates rise and FDIC-insured investments are returning 5% or more? It makes little sense to invest in an unsecured loan that is paying 6% when you can get an equivalent return with no risk.

What will happen to the interest rates for p2p lending in a higher interest rate environment? While I don’t have the definitive answer (no one does) I can provide my own theory.

Borrowers have shown a capacity to continue borrowing in any economic cycle. There will still be demand, of that I am confident. But interest rates will have to change. Right now the lowest interest rate available at Lending Club is 6.03%, at Prosper the lowest rate is 6.04%. And herein lies the problem. The expected return to investors for these loans (after expected losses and service charges) is going to be between 4% and 5%.

That is not a bad return today but when FDIC-insured investments return 5% it starts to look unattractive. So rates will have to go up in order to attract investors. If the Federal Funds Rate goes to 5% again I think we will see borrower interest rates begin at around 8% to ensure a return to investors of 6% to 6.5%.

Will this mean the most creditworthy borrowers will look elsewhere? Possibly. But keep in mind other borrowing options will also be more expensive.

So, I believe that the impact of higher interest rates will not be that dramatic for p2p investors. We might see a slight increase of the average risk profile for the most creditworthy borrowers but apart from that I don’t foresee any major changes.

What do you think will happen if interest rates begin to rise? As always I am interested to hear your comments.

{ 15 comments… read them below or add one }

writing2reality April 26, 2013 at 7:06 am

I agree with you Peter that I don’t believe the overall impact will be that significant. Peer-to-peer lending has barely begun to scratch the surface of the unsecured loan market. As a result, I don’t believe there will be a lack of demand from borrowers. Of course when rates rise, I too believe that there will be a corresponding adjustment to pricing in the p2p world, as there will be in the rest of the financial world. With this interest rate adjustment, I also don’t believe there will be a significant shortage of investors.

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Bryce M. April 26, 2013 at 7:07 am

The cost to borrow will increase everywhere, and thus credit demand should fall. Investor demand is harder to predict. Nominal interest rates will rise on the p2p platforms, but I suspect the differential between them and the risk-free rate of return (treasuries) will fall. Thus, p2p won’t be quite as attractive to investors.

We may not see as fast of growth on the p2p platforms, but it’s such a nascent industry I think there will still be growth. That is, I think that the discovery rate of p2p lending as an asset class will trump the interest rate.

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Daniel G. April 26, 2013 at 10:21 am

In the 1980’s when interest was high, I’m assuming average credit card rates were higher. I’m not finding anything from the 1980’s, but the average rate in 1991 was over 18%, compared with 12% last year. So, if fed-money gets more expensive, I’m sure it will push up borrowing rates across the board.

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investforfreedom April 26, 2013 at 10:27 am

“but when FDIC-insured investments return 5% it starts to look unattractive. So rates will have to go up in order to attract investors. If the Federal Funds Rate goes to 5% again I think we will see borrower interest rates begin at around 8% to ensure a return to investors of 6% to 6.5%.”

Peter, how is it that rates could ever rise to 5% with $16 trillion in debt and counting. For each percent rise, you are talking about $160 billion dollars in interest payout in order to service the debt. With 5% rise, it means a whopping $800 billion! Bernanke himself acknowledged that U.S. couldn’t afford to have a substantial rise in rates in the wake of the debate about debt ceiling and the possibility of a U. S. default.

It might be argued that the majority of the debt is not held by foreign government entities, so the interest payout will get recycled back to the U.S. Nevertheless, foreign sovereign entities now hold over $4 trillion in U. S. debt: http://www.treasury.gov/resource-center/data-chart-center/tic/Documents/mfh.txt This is not chump change. With every percentage rise in interest rates, the U. S. government has to pay out $40 billion to foreign governments. If rates go to 5%, it means $200 billion.

Besides, we have not seen low interest rates fueling the velocity of money circulation–and hence inflation. In fact the velocity of M2 is at a 50 year low: http://research.stlouisfed.org/fred2/series/M2V

ZIRP or Low IRP is here to stay. We are not Japan, but regardless, the more debt we accumulate, the harder it is to raise rates on ourselves.

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Peter Renton April 26, 2013 at 11:05 am

Thanks for the comments. For the record I don’t expect rates will rise to 5% any time soon. But I think we can all agree that zero percent interest rates will not be with us forever. If I had to guess, though, I would say rates will remain below 2% for the rest of the decade. This will mean p2p should be considered an excellent investment opportunity for many years.

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investforfreedom April 26, 2013 at 12:54 pm

Peter,

This much I am sure:
(1) The $16 trillion+ debt is only going to increase.
(2) They “pay” the debt by eroding it away through inflation.
(3) But they definitely don’t want high inflation, much less hyperinflation. They want low to moderate inflation to erode the debt. And that is what they are getting–1.5 percent in the month of March–given the lowest velocity of monetary circulation it has been in the past 50 years. (I don’t want to get into Shadowstatistics for now.)
(4) They wouldn’t raise rates higher than the rate of inflation; otherwise, they couldn’t dilute the debt.
(5) You can get a sense of where rates are heading based on the formula above.

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Roy S. April 27, 2013 at 7:14 am

(1) I have to disagree. We are headed to a point where the US will no longer be able to borrow. Once that happens, the US will default and the $16 trillion+ will disappear. At this point, we need SIGNIFICANT cuts in spending…and that will happen…when Washington freezes over.
(2) Exactly…unfortunately very few people understand this.
(3) If the velocity of money ever picks, do you think the Fed will be able to reign in inflation? Unless it is a very slow pick up, I foresee hyperinflation. (You should get into Shadowstats. The government is trying to change the way inflation is calculated once again to reduce Social Security COLA increases, but it also affects a lot of things…think tax brackets for something that hits a little closer to home…assuming that most people have a job and will get a raise…okay maybe not so close to home anymore for most…)
(4) I haven’t looked to much into TIPS for several years…and even then it was only cursory. Those are indexed to inflation. Obviously false inflation figures will impact returns. What percentage of the outstanding debt is held in TIPS? I agree with your general point, though.

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Roy S. April 27, 2013 at 7:26 am

If interest rates rise, ceteris paribus, demand will fall. However, I think an even bigger factor that is being missed is the current workforce participation rate. We are at the lowest workforce participation rate in over 30 years (63.3%). I don’t foresee an increase in interest rates by the Fed until the economy picks up…if it ever does pick up. At the point we start seeing an increase in interest rates, I believe we will already have a higher workforce participation rate. I think this will bring more people into the market for loans providing a boost to the demand for loans that would otherwise see only a negative impact from the increase in interest rates…whether this will have an overall net positive effect…I would like to think so, but I do not know.

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Rob April 30, 2013 at 12:31 pm

I didn’t see above where anyone addressed the impact of rising rates on an existing portfolio. It seems clear that rising rates decrease the value of an existing portfolio in the same way that rising rates decrease the value of existing bonds. When interest rates rise it is likely inflation will be rising as well. This inflation will reduce the real returns of an existing portfolio, and the longer the duration of the portfolio the bigger the hit. Existing borrowers will benefit by having the priviledge of paying off their loans in less valuable inflated dollars. If the theory is higher interest/inflation in the near term then I would think minimizing portfolio duration would be very important. I am very new to P2P (it’s only my second comment) so file this under newbie. This is all probably just P2P 101 to those more experienced.

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Peter Renton April 30, 2013 at 2:32 pm

Rob, You make an interesting point. New 5-year loans could be priced very differently by the time an existing 5-year loan reaches maturity. We have already seen this happen with regular changes to pricing of existing loans.

While the value may fall unless you are looking to offload your loans on the secondary market any loss from higher interest rates is more of an opportunity cost than an actual cost. But given that we are receiving principal and interest payments every month even that opportunity cost will not be that great given that we can reinvest our accumulated cash every month in higher interest loans.

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Adrian May 1, 2013 at 1:37 pm

I also think it’s important to consider why interest rates would rise and to look at both credit risk and interest rate risk. If there is a “stagflation” scenario where the Fed needs to raise rates to combat inflation but the economy is growing anemically, then this will be unequivocally negative for a fixed rate loan portfolio. However, in a more typical scenario where interest rates rise along with a growing economy, then there should be a positive impact on default rates. If X% of borrowers default each year when the economy is growing at 2%, then something less than X% should default when the economy is growing at 3% or 4%. This could be an offsetting factor for the duration risk. So while the gross interest rate on each loan is fixed, your net return after defaults could improve with a rise in rates.

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Peter Renton May 2, 2013 at 6:46 am

Adrian, Good points. One would hope that in an environment of increasing rates that we would see a corresponding increase in growth.

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David May 23, 2013 at 5:28 am

From a mortgage point of view I think many people are simply on the fence; no hurry to make a move; there is no need. I believe if the rates start to move up it will freak out many people. I believe it might be the catalyst to get this economy moving

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Rob July 10, 2013 at 7:12 pm

So here we are in July 2013. Seems like rates are rising and (we hope) economy is at least slightly improving. Latter part of this month will be telling when public corp earnings all get announced for Q2. Anyone see any new telltale signs on the topic of this thread? For the moment, I am going with the theory that as long as I keep buying new loans on a rising int rate scenario, and LC properly sets loan rates to ensure investors get a good return, all should continue in a good direction. We will see, over next 6 months.

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Peter Renton July 11, 2013 at 6:48 pm

I think it is way too early to see any signs of rising rates trickling through to p2p lending. I believe we would need at least a couple of percentage points increase in the 10-year before we see much impact on rates at LC and Prosper.

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