Risk Adjusted Returns in Peer-to-Peer Investing
As Peer-to-Peer Lending moves from an alternative to a mainstream investment, investors must look deeper than simple headline returns. Peer-to-Peer Lending (P2P Lending) is the process of connecting investors directly to borrowers by circumventing traditional banks and financial institutions. Investors ranging from individuals to institutions are being offered returns of up to 15% pa.
In 2015, the UK P2P Lending industry delivered record high volumes of £2.68bn in loans arranged, a near 100% increase on 2014. 2016 volumes are predicted to double again. The P2P industry is over 10 years old with Zopa, a consumer lending platform, being one of the first to the market. The sector can be broken down into three categories: Consumer loans, SME loans and Property loans. Each offers very different risk profiles with many platforms, mainly consumer and SME, providing little to no security over the loans originated.
In the current long term low interest rate environment, new investors are being attracted by the headline interest rates. However, when investing in P2P Lending, we encourage investors to dig deeper not only at individual loan level but at platform level and to fully understand their risk-adjusted returns.
There is a well known quote “Any fool can lend money, the trick is getting it back.” This has never rung truer as when investing in P2P loans. Investors need to understand how monthly interest will be paid and how the loan principal will be repaid.
A smart way to invest in P2P loans is to ensure that the borrower offers security to support the loan. Security can take many forms, but the most traditional and reliable method is pledging an asset such as an income generating property because it provides a secondary source of repayment. The income (rental income) pays the monthly interest, but if the borrower is unable to pay the interest or the loan principle, the security can be sold and the proceeds used to repay the lenders.
Investors in unsecured loans, whether P2P or otherwise, should be paid a premium to compensate them for the additional risks they take — risks that investors in a secured loan are protected from. However, there is a similarity of yields between secured and unsecured P2P lending, meaning that unsecured loans are not offering a premium rate for their increased risk. As such, investors in secured loans can benefit from the same or better returns but also take advantage of the added protections, both credit risk and interest rate risk, which secured loans provide.
Not only does security at whole loan level increase risk adjusted returns, but the capital structure of the loan can be “broken down” into loan to value (LTV) based tranches which are ranked by priority. Priority is ranked by senior, junior and mezzanine tranches. The senior tranche, being the lowest loan to value has the first priority of repayment but offers a lower return than say the junior tranche which is paid after the senior. The return on the junior is higher than the senior. Therefore the risk adjusted return of a senior loan vs the risk adjusted return of a junior loan vs the risk adjusted return of an unsecured loan should not be the same.
At Proplend, we quickly recognised that not all P2P investors have the same risk parameters and return requirements. This led us to pioneer the first Peer-to-Peer loan tranche model offering investors attractive fixed income returns across three loan to value based tranches.
Our Tranche A, 0–50% LTV, to date has returned 6.28% pa*, similar to returns offered via unsecured P2P loans. Proplend Investors benefit from not only the security but also the 200% capital protection that Tranche A offers.
We encourage investors looking for attractive rates on fixed income returns to investigate this asset class. It is rapidly growing and becoming recognised as a mainstream investment sector with a new Innovative Finance ISA being launched in April 2016. We encourage you to learn more, but caution you to perform research deeper than just the headline returns.
To learn more visit www.proplend.com
*after fees but before bad debt & taxes.
Proplend Ltd is authorised and regulated by the Financial Conduct Authority, and entered on the Financial Services Register under firm registration number 662661 Proplend Ltd is not covered by the Financial Services Compensation Scheme.
