Bonds vs P2P Loans: A Primer

Fixed income yields are terrible right now.

You know you need to build a portfolio of more than just stocks to properly manage risk. The best portfolios have different asset classes in them that don’t correlate with each other, aiding us in proper risk management. Both stocks and fixed income in a portfolio are needed to build a long-term profitable portfolio.

With these horrible yields in fixed income, how do you accomplish this in today’s market and make money?

Let’s look at some of these fixed income options and see how they compare. This is a beginning analysis of marketplace loans versus bonds.

Long Term Government Bonds

It doesn’t seem like that long ago when government bonds were considered the ‘risk free’ investment. Portfolio calculations of risk took the risk premium based on the actual or potential returns over and above Treasuries. After all, the US Government was never going to default on a debt, right?  Well, that used to be true.  Confidence in our government to do anything seems to be shaken at the moment and that lack of confidence extends to government bonds and how they might perform in the future.

The longest term US Government Bond, the 30 year, has a rate that is right around 2.5%. This is low by all historical standards.

Today, inflation is near 1%. This means a real interest rate of 1.5%. Is that rate high enough to compensate you for the risk of holding onto a government bond for 30 years?

For most people, it isn’t. Long term government bonds are an option but a not great option when it comes to balancing the risk/reward ratio.

Summary

Type: Long Term Government Bond

Term: 10 to 30 years

Risk: Moderate (higher than people think it is). The greatest risk is not keeping up with inflation.

Quality of Investment: Returns not great for real risks involved and very long term required to hold.

Sovereign wealth funds, governments, and endowments need to keep buying Treasury bonds as it is one of the only markets large enough to absorb all the buying they have to do to put that money to work. Even at these paltry interest rates….

We are not a sovereign wealth fund. We have more choices.

Short Term Government Bonds (T-Bills)

T-Bills have much shorter terms ranging from one month to one year. Rates for one-month T-Bills are 0.254% and for one year are 0.642%. With an annual inflation rate of 1% we have a nominal real rate of return on the one-monthT-Bills and are losing money to inflation if we hold T-Bills for one year.

One year T-Bills are obviously not a good investment.

The one month at 0.254% monthly over 12 months does give you a positive real rate of return on your money (3.048% -1% inflation), but some of that return is eaten up with transaction costs since you have to buy new T-Bills each month meaning 12 transaction costs per year.

Summary

Type: T-Bills (Short Term Government Bonds)

Term: up to 1 year

Risk: Low

Quality of Investment: The shorter the term, the better and a good place to park cash for a short period of time. One year has a negative real interest rate.

T-Bills have their place especially for holding cash in a short term, temporary way while waiting to deploy funds into a more effective long term investment.

Now that we have looked at US government bonds, let’s look at some more options.

Corporate Bonds

If you are on a quest for yield, the US Government as bond issuer is probably not the place for you. We’ve seen that they don’t do great on our risk/reward scale either.

Since large companies issue bonds too, we need to give corporate bonds a look.

Corporate bonds are underwritten by a bank and issued with a rating from one of the 3 big rating agencies: S&P, Moody’s or Fitch. Corporate bonds should be a higher yield option for the fixed income portion of a portfolio. Yields on corporate bonds have been in steady decline over the last few years too.

A quick glance at some corporate bonds from the NY Times show some bonds by rating.

For instance, BNP Paribas, who owns American bank known as Bank of the West, who is A-rated by S&P is yielding 1.67% on a bond maturing this September. Verizon, who is BBB+ rated by S&P, is yielding 5.24% on a 30 yr bond. Lastly, Sumimoto Financial, rated A- by S&P is yielding just a hair under its coupon of 2.83% on a 5 yr bond.

To find a double-digit yield, we had to search for a D rated (by S&P) bond with a 2022 maturity for Chesapeake Energy (CUSIP: CHK4116807) to find a yield of exactly 10.00%. A D rating means they have already failed to pay on at least one of their other obligations and a default is likely. A 10% rate is not exactly how you (or we) should be compensated for that kind of risk. And we have to hold this bond and hope they pay for 6 more years.

If you want to gamble you should go to Vegas, not gamble just to earn 10%.

This chart from the NY Times shows yields for investment-grade and high yield corp bonds

As you can see, rates are very low at 3.42% for investment grade and 6.44% for high yield, which are normally referred to as “junk” bonds. These rates are pretty slim for the risk we are taking. They do present some yield over and above US Gov’t bonds though.

Remember we are in a historically low-interest rate environment. For all of these bonds, but especially corporate bonds, if interest rates rise then the value of our bonds will fall.

Who knows how long these historically low interest rate levels will last?

Summary

Type: Corporate Bonds

Term: Up to 30 years

Risk: Moderate on Short Term, High on Long Term and Junk

Quality of Investment: Investment grade bonds, especially in the short term, are probably solid.  The longer the term and higher the yield the more uncertain due to rate environment and poor credits on the junk bonds.

If government bonds and corporate bonds are either low yielding or too low yielding for the risk you are taking, then how do you allocate the fixed income requirement of building your portfolio?

Peer to Peer/Marketplace Loans

To be a good fixed income investment, we need something that encompasses borrowing and steady repayment over time. We need to be able to select the type and average term of the loans we want.

And we need to be compensated for our risk.

Peer to Peer loans are a bet on a specific part(s) of the US economy. There are platforms that only do small business lending, or student loan refinancing or prime borrower (the best credits) unsecured consumer borrowing. US consumer lending is so large that if it was a country it would have the world’s 6th largest GDP.

In this space, Lending Club (this is an affiliate link if you are a new investor) gets the most looks and the most talk because they have been publicly traded for a while now. They are not the only platform out there.

Prosper, who is privately held, swims in the same pool that Lending Club does. Kabbage and Funding Circle are small business lenders. P2BInvestor does business receivables financing. Realty Mogul, Fundrise, and Patch of Land do real estate lending.

Investments on different platforms can help you get the fixed income duration you are seeking and spread the risk around too.

Whether the loan is secured by assets or not, nearly every platform has interest rates above 5-6% and often in the double digits.

Funding Circle says the average investor can expect a rate of 7.3%) after fees and non-payments.

Kabbage charges a combination of rates and fees, a good portion of which goes to its investors, and their rates are in the low teens when combined into an APR as seen below. This 4% rate fee for 6 months is 4% for each of the first 2 months and $100/month at the approved rate so if that rate is 1%, as an example, then the total fees for a 6 month credit line are ($400 for 2 months and $100 for 4 months) $1200 or 12%.

Lending Club’s lowest rates are 5.32%-8.59% for A grade.

Just a small initial glance at p2p lending and the rates are much higher. On these platforms, we are compensated for our risk.

So how do we choose which platforms and how do we invest wisely?

There are lots of options for investment including 7 platforms for retail investors. In my upcoming book (YES I am writing a book), I am going to outline them all in much more detail. Again, this is just an introduction and initial comparison.

So let’s sum up peer loans compared to bonds

Summary

Type: Peer to Peer Loans

Term: 18 months to 5 years (usually)

Risk: Low on the Excellent Grade (A grades), Higher as you go to lesser credit grades

Quality of Investment: More flexibility and versatility for portfolio building based on risk, duration, rate. Some diversification as money is spread over many borrowers. Go get higher rates and the defaults that come with it or get lower, slower steadier rates or mix and match. Proper compensation for risk. The risk/reward works here. Does not correlate with other financial markets.

We will dive much deeper into this analysis in a couple chapters of the upcoming book.

The only real downside to this market is that it has not experienced an economic downturn and we have no idea how these credits will react to that. The other fixed income options won’t do so well with a drastic turn of economic events either. Corporate bonds, in particular, will do very badly when the next recession hits. Government bonds would get more attention and buying interest but bid up bonds mean even lower rates and negative real rates for certain.

The only place in fixed income where we are paid for the risk we take is in peer to peer/marketplace loans. You need to take the portfolio building ideas of having stocks, bonds, cash, real estate and other assets and take the bond part out of this equation and substitute p2p lending for its fixed income potential instead.

Bonds do NOT pay us properly for our risk. Marketplace loans do and WE get to select the risks we want to take.

About the author

Stu Stu Lustman, the author of this post, is a Credit Analyst by trade trying to bring Commercial Credit Analysis techniques to the world of Peer to Peer Lending. Check me out on Twitter, LinkedIn and Google+

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