The following article is the first of a two part series by Matt Shibata, CFA, looking at P2P lending as a fixed income asset class from the perspective of an investment professional. Matt is a Portfolio Manager at Morling Financial Advisors. He invests in P2P loans via retail channels and advises clients who invest in P2P (and other asset classes) via institutional channels. Matt can be contacted at email@example.com.
Much of the discourse and analysis surrounding peer-to-peer (P2P) lending and investing has been written by, and targets, individual investors. Although there are institutional investors in the space, P2P is still largely ignored as it is a relatively small, misunderstood, and difficult-to-access asset class. Thus, the purpose of this article is two-fold. Firstly, I hope to consolidate some of the commentary out there to place P2P lending into a standardized fixed-income framework and, secondly, use this framework to make a case for P2P lending.
First, some terminology:
- P2P Originators or P2P Sponsors: Lending Club and Prosper, among others.
- “Price” and “Yield” are used interchangeably, as they are opposite sides of the same coin. Generally, price and yield always move inversely to each other. I have tried to use both where applicable and possible.
- Excess Return: Expected return above that of another investment of similar risk. Other definitions do exist though.
- Asset-Backed Security (ABS): Type of bond most analogous to a portfolio of P2P notes. ABS are usually backed by aggregated financial assets like loans or leases. To be clear, the claim on the future cashflows is the asset (think accounting assets, not a physical asset). Usually, they are consumer loans (like credit cards or student loans) and are sometimes collateralized (such as auto loans or home equity loans).
P2P Lending Through a Fixed-Income Lens
Ever since I heard about P2P lending, I have enjoyed reading blogs on the subject (such as this one) and individuals’ accounts of their experiences with P2P. An interesting pattern, though, has been to read someone’s observations, discoveries, and/or theories which are brand new to them (or even the P2P community) but are well-known concepts in the field of fixed-income investing. I think this is exciting in that the process of discovery is always thrilling, but also an opportunity for more education and learning for P2P investors; they do not need to reinvent the wheel. By utilizing traditional fixed-income tools, P2P investors can better quantify and manage risks and returns.
For instance, many people (maybe less so now that the asset class is a bit older and has more literature) who share their P2P investing strategies make a sudden shift at some point, from focusing on minimizing defaults to focusing on maximizing returns. Usually, this takes the form of, “I used to invest solely in grades ___ and above, but now only invest in grades D and below.” The idea that minimizing bond defaults does not necessarily lead to higher returns was discovered in the 1980’s, which is to say that it was both a major discovery (in such an old market) and also already known before the advent of P2P lending in the 2000s.
Just 30 years ago, professional fixed-income managers evaluated bonds on an individual basis, much as some P2P investors do who read each loan description and try to judge the likelihood of default. Back then, bonds whose credit rating dropped below investment-grade were summarily sold, as the risk of holding them was deemed too high. In the 1980’s, Michael Milken (then the “Junk Bond King,” later a convicted felon, and now a prolific philanthropist) discovered that while “junk bonds” (those rated below investment-grade) were individually risky, they were so uniformly underpriced (meaning that yields were high) that a diversified portfolio of them could do much better than an investment grade portfolio with lower default rates. Statistically, the returns from higher rates should more than offset the losses of expected defaults.
The P2P originators and countless websites enumerate the many characteristics and benefits of P2P investing. Most align with one of the following concepts.
- Match borrowers and savers, but cut out the “middle man” (mainly banks)
- Transparent borrower and underwriting data
- Consistent cash flow
- Lowered risk from diversification benefits
- Secondary market liquidity
- High yields
Each of these attributes apply to nearly all fixed-income products, except that the yields in P2P investing today are much higher than in other markets. Initially I was very skeptical of the performance claims relating to P2P lending, as the returns seemed much too high for what is essentially an asset-backed security (ABS). However, upon further due diligence, I found P2P investing possesses a single idiosyncrasy which sets it apart from traditional ABS and other fixed-income vehicles and is responsible for the attractive returns. Without this feature, I do not think P2P lending would produce high returns or attract much investor interest.
The P2P Opportunity
I have seen many investments promise high returns or yields, only to learn they are highly leveraged, have volatile cash flows, or use creative methodology/definitions when calculating “yield.” If any investment is offering a high return potential, my first question (and perhaps yours) is always, “Why haven’t other investors already jumped in and bid up the price (driven down the yield) to a level where it no longer offers excess return?” Although there are many characteristics that make P2P lending a legitimate asset class, the main factor that sets it apart from other fixed-income asset classes and drives the much higher returns is the fact that P2P originators set the price instead of the market. In most other fixed-income markets, the offering price (yield) is set by the market either directly or indirectly. Typically, if something is underpriced and offering superior risk-adjusted returns, it will be bid up to a price where it no longer offers a superior return.
For example, when the US Treasury issues Treasury bills, notes, and bonds, it holds an auction. Prospective buyers submit a bid stating the lowest yield that they are willing to accept. The Treasury then sells the debt to each bidder, from lowest acceptable yield to highest, until the prescribed amount of debt is sold (all buyers get the same price, which is the highest yield). Similarly, when many corporate bonds are issued, the underwriters look to the secondary market to determine pricing, as that is a good indication of what people are willing to pay for a new offering. This would be akin to the P2P originators using data from recent Foliofn transactions to set prices/yields on new loans. As many of you know, the average yields on Foliofn are a bit lower (prices are higher) than buying directly from the originators.
I believe P2P represents an excellent investment opportunity as long as this pricing structure remains in place. For the time being, returns (prices) are above (below) where market participants would transact, leading to excess returns and more demand for than supply of loans. The originators have publicly stated that they are focused on originating quality product to keep investors happy and returning. However, I can envision price/yield changes being made down the road to remedy the supply/demand imbalance or to increase loan volume. However this does not seem to be a near-term risk. There are a myriad of risks to consider in fixed-income investing, from macro themes like inflation to market concerns like liquidity.
In tomorrow’s post we will focus on the two main risks in fixed-income: credit risk and interest rate risk and how they apply to P2P.