A friend and I were talking this week about how peer to peer loans in a portfolio is not unlike a bond mutual fund. In fact, it's exactly the same. A bond mutual fund is a fund that is many bonds together all with different rates and terms in them paying over time.
Loan duration is expressed in number of years as the sensitivity of price to changes in interest rates. It is a measurement of how long it would take for the price of the bond to be repaid by its internal cash flows.
Bond interest rates are so low, especially for the risk you take in buying a bond that peer loans seem like they are much safer for those of us who know these loans exist. Lucky us.
Who Cares About Duration?
What we have with our portfolio of peer loans is a bond portfolio. Bonds move when interest rates move. However, they move in opposite directions. When Interest Rates Rise, Bond prices fall and the opposite is true with Interest Rates falling means Bond prices rise. We can sell our loans on Folio but there is not a big liquid active secondary market like there is for bonds.
An example of how bonds and interest rates move opposite each other
Bond A costs $1000 and pays 5% per year for 3 years.
Interest rates rise from 5% to 7% so what is today's bond price? Today's bond price has to match the current interest rate of 7% for the market in case a new buyer wants to come in today and buy it so that means the price of our bond has to decline.
Our interest on our bond was 5% which is $50 per year. Now that $50 per year has to equal 7% since that is the market rate for other buyers. if we take our $50/7% or .07 then our answer is $714.28. Our $1000 bond is now worth $714.28 because interest rates rose. $714.28 is what someone buying this bond today will pay in order to get the market rate of 7%.
I know this is confusing so go back and look at it one more time to see why Bond Prices and Interest Rates move in opposite directions from each other.
With interest rates so low now, where do you think they are going to go? Lower or Higher?
How We Need to Look at Duration
The actual calculation for Duration is really complex although there are some calculators. Most people's duration is what is known today as the Macauley duration for bonds. Where duration matters for us is that we essentially have 2 choices for our loan terms: 36 months and 60 months. I have a 3rd choice because I lend in Bitcoin as well over a shorter term. It's important for us to see what the remaining terms are on our loans so we can see if we are at the long end (closer to 5 years) or shorter end (closer to 3 years) or in between somewhere. The lack of liquidity for us means we cannot really just up and sell our loans easily anytime we want to so our p2p lending version of duration is more like the time left in the term of our loans.
A simpler calculation that really helps us involves our good friend Excel. Start here in column A
In this example we would normally be calculating the Present value of a stream of payments (B1) or a monthly payment (B4) on a fixed loan amount like a mortgage. Next, in cell C1 put in the sum total of your Peer Loan Note value. As of August, My Note Value on Prosper is $2698 and on LC its $2898 or a total of $5596.
Next in B5, put your target interest rate. Mine is 12% or 1% per month. Put in the monthly rate though, not the annual rate. So my B5 says 0.01 for 1% monthly. In B3, our future value is zero but that will mess up our calculations so put in 1. Next, put in your Prosper and LC monthly payments received both principal and interest in B4. I received $78 in Prosper payments and $81 in LC payments giving me a total of $159. This number has to be negative so our Present Value (PV is positive) so my B4 says -159.
So right now we have C1, and B3-5 filled out. Mine looks like this:
Now we need to play around and try to get a PV that is as close to C1 as possible. Almost all of my loans are 60 months so I started with 60 months in B2 and calculated PV and came up with $7218.78, which is way more than my principal balance of $5596. Next I cut the number of months in half to 30 and the number came up as $4143.72, way less than my balance. I split the difference and tried 45 months and it got me to $5795. Very close to my principal balance.
You will need to play around with it and plug in different numbers in B2 to get different PV's in B1.
If you do your PV formula correctly, EVERY time you change the month but nothing else the formula will recalculate. It turns out that my number where PV equals my principal value is 43 months. here is how mine looks:
So who cares? This number tells me how many payments of $159 will be needed to pay off my principal balance remaining. This is very close to a bond calculation of duration. My average loan term remaining is 43 months or 3.5 years.
Remember our definition of duration, its sensitivity to changes in interest rates. Interest rates impact longer durations more than shorter ones. If my average loan term remaining was 53 months instead of 43 months then a change in interest rates would be more impactful for me and my choices of how to invest my money.
We can invest to protect ourselves if we think Interest rates might hurt us too much. It even has a name: Bond Immunization. It's an attempt to minimize interest rate risk in a portfolio of bonds or loans. If you did this calculation and came up with a number near 60 months, you can immunize your portfolio a little bit by picking the exact same loans you pick now but picking 36 month term loans instead. That one thing alone will lower your average term remaining and your vulnerability to interest rates.