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Peer-to-Peer Lending: Is Higher Yield Worth the Risk?

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Advisors with clients looking for yield have several choices in today’s market: They can invest in dividend-paying stocks, but those yields will be under 5%; in high-yield bonds, which can yield as much as 8% currently; or peer-to-peer (P2P) loans, whose yields are closer to 11%, according to the latest stats from Lending Club, an online marketplace for such loans.  

As with most investments, the higher the potential return, the bigger the investment risk. The P2P loan market delivers higher yields to investors than other debt markets, but it’s far less liquid and less regulated. The volume of  P2P loans in the U.S. doubled between 2014 and 2015 to $6.6 billion, but that was just 60% of the high-yield bond issuance in the first week of April this year.

Still, advisors looking for alternative investments may be interested in P2P.

Jeffery Nauta, a principal at Henrickson Nauta Wealth Advisors in Belmont, Michigan, says his firm has been investing client funds in P2P loans for more than three years, via a hedge fund, because of the relatively high yields.

“The primary driver of our decision to invest was an expected return above high-yield credit and uncorrelated returns, which we have experienced over the last three-plus years,” says Nauta. More specifically, explains Nauta, the returns on P2P loans are not closely correlated to the returns on the high-yield market because the borrowers are different. P2P loans serve consumers; high-yield loans serve corporations.

How the Market Works

P2P lending is essentially crowdsourcing for debt. Borrowers with credit scores near 640 and above — considered prime borrowers — who are unable to secure a bank loan or who would prefer a loan charging a lower rate can apply for a loan at one of a growing number of online marketplaces such as Lending Club or Prosper. If the application is accepted, the loan is posted on the website for investors to review.

Once enough investors agree to fund the loan – which is divided into pieces – the borrower receives the money and begins to make monthly payments to the marketplace, which are then divvied up among the lenders who financed the loan. There are usually many lenders per loan because the minimum investment per loan is usually only $25. The loan’s rate is fixed, and the term usually ranges between 24 and 60 months.

Investors finance multiple loans, increasing diversification and reducing their credit risk. They receive monthly payments from each borrower that can then be reinvested or withdrawn.

“The concept isn’t bad,” says financial planner Eric Roberge, whose firm, Beyond Your Hammock, is based in Boston, but he says the advantage skews toward the borrower rather than investor. “From an investment perspective, I think they are just ok…. We don’t have a long history of performance, so we have no idea how things will turn out.”

Roberge prefers bond funds and high-yield bonds to P2P loans. “If I had a choice to trust a group of companies or a group of individuals, I’d take the companies the majority of the time,” says Roberge, but he’s not against investors interested in P2P deploying “a grand or two … to see what happens.” The P2P lending market, which started about 10 years ago, is currently dominated by institutional investors such as banks and hedge funds, leaving individual investors at a disadvantage to get in on the most promising loans.

Goldman Sachs is building its own lending site. JPMorgan announced a partnership with OnDeck Capital, a P2P lender for business loans, and along with other banks like BBVA and Credit Suisse has invested in one of Prosper’s funding rounds. In addition, Wells Fargo through Norwest has invested in Lending Club.

Given the growing presence of institutional investors, “most popular loans are now funded in five seconds,” says Emmanuel Marot, founder and CEO of LendingRobot, a robo-advisor for individual investors in the P2P market. “When you want to put your money in, you have to choose wisely.”

LendingRobot, which recently introduced a mobile app, helps investors make that choice, reinvest interest payments and sell their shares of loans on the secondary market, depending on the type of account they open. It may be the kind of tool that advisors and investors need to invest wisely in the P2P market. It tracks the loans offered at the three major P2P online marketplaces — Lending Club, Prosper and Funding Circle – and can link an investor’s accounts at all three into one single LendingRobot account.

— Check out Deep-Pocket Investors Ready to Take the ‘Peer’ Out of Peer-to-Peer Lending on ThinkAdvisor.