When searching for portfolio diversification beyond traditional asset classes, investors may find interesting opportunities in the household sector in terms of absolute and risk-adjusted returns. In Western economies, the household sector represents on average just over a half of the economy.
A fund structure investing in direct small loans to households is one way investors can gain exposure to high-quality personal and small company loans efficiently. To explain why direct small lending has evolved into a mature market of significant size in recent years, here is a brief introduction to this asset class.
What is direct small lending?
Direct small lending, also known as peer-to-peer or alternative lending, refers to lending that takes place through online platforms rather than through traditional lenders such as banks. The platforms match borrowers to investors seeking an investment with an attractive risk-return profile. While the market originated with retail investors lending to borrowers, the asset class has matured over the years with significant funding now being provided by institutional investors. The scope of credit risks underwritten by direct small lenders has grown from solely unsecured personal loans to encompass small company loans, cars, real estate, student loans, amongst others.
Typically, household loans have relatively low initial balances with an average term of three to five years. The most common direct small household loan is fully amortizing, with a weighted average final term of 3.5 years and an average balance of around USD 10,000.
How does direct small lending work?
By creating a match between borrowers and loan investors, direct small lending provides households with a variety of financing solutions. It has especially proven to be an effective tool to reduce household interest cost by consolidating existing debt or reducing revolving credit card debt. In moving towards an amortizing instalment structure, households can benefit from a lower interest rate than would be charged on a comparable revolving balance. The success of direct small lending is due, in part, to the typically progressive use of technology during underwriting, streamlining the traditional lending process.
Depending on the platform, investors have the ability to choose to which loans they want to be exposed to. Most common are either active loan selection or by taking passive pro rata allocations of loans that meet certain criteria, such as loan type, size, duration, credit risk. The direct small lending platforms take care of the relationship with the borrowers, acting as servicers for the loans, managing the cash flow from borrower to investor, net of servicing fees. Other fees may include loan origination fees, which are usually charged to the borrowers. Investor exposure is limited to the potential economic benefits and risks stemming from the loans.
While many direct small lending platforms perform their own loan origination and monitoring the underwriting models for quality and compliance with laws and regulation, they may use banks to perform these services.
Display 1: Typical Direct Lending Structure Overview. For illustration purposes only.
Why is the opportunity compelling today?
For years, the focus of investors has been on corporate and government debt overlooking a significant part of the economy. While current economic conditions remain a key concern we believe that, perhaps counter-intuitively, investors might do well by looking towards prime household credit compared with the corporate sector. Lending standards for personal loans have been tightened and debt levels have fallen drastically since the debt crisis of ’07-’09, from 99% debt to GDP in 2008 to 75% currently. By contrast, corporate debt is near a record high of 80% of GDP 1. Furthermore, household purchasing power is increasingly being supported by fiscal policy (partly at the cost of businesses via higher taxes) while unemployment continues to be at record lows.
These are the four main reasons why direct small lending is a compelling alternative strategy for investors:
- Attractive yield + low duration. In the current market of rising interest rates and inflation, the short average duration of personal loans reduces sensitivity to the interest rate fluctuation and allows investors to reinvest cash at higher rates.
- Diversification in terms of asset class and geographical focus. Direct small lending offers diversification from other major asset classes such as traditional corporate credit, as the underlying credit exposure stems from households, rather than from traditional fixed income allocations like corporate or government credit. Additionally, within the asset cIass itself an investor can find a wide range of diversification in terms of geographical focus, loan segment, duration, credit quality, etc.
- High-quality loans. Traditionally, access to personal loans was limited to ABS structures. Now, direct access with active loan selection allows us to pick loans with a much higher quality than you would traditionally get, by focusing on HENRYs (High Earners Not Rich Yet), borrowers with above median incomes who are less impacted by higher inflation.
- Strong performance in stress periods. Personal loans have demonstrated performance throughout multiple stress periods, with resilient through-the-cycle returns and limited defaults. During COVID-lockdowns for example, direct small lending platforms tightened credit standards, decreased underwriting volumes and increased borrower selectivity, and increased borrower interest rates. By offering short-term loan modification programs to borrowers impacted by the pandemic, borrower defaults were reduced as the economic backdrop stabilized.
Historic monthly returns of direct small lenders in the US, since 2005:
Average annualized return: 7.8%, maximum monthly drawdown of -6.45% in March 2020.
Source: Dynamic Credit
As a private-credit asset class focusing primarily on households, direct small lending is a compelling strategy for investors looking for diversification to reduce exposure to risky corporate and government debt. With the modest duration, investors in direct small lending platforms are ideally positioned to limit their exposure to interest rate fluctuation in an inflationary environment. With its high-yield, low duration and amortizing characteristics, direct small lending stands in stark contrast to most corporate debt. Direct small lending is here to stay and will play an important part in investors’ portfolios through the cycle.
1 Source: The Economist, ‘As interest rates climb and the economy cools, can companies pay their debts?’; 3rd July 2022