P2P vs Bonds

09 July, 2015

We have had a few questions about the difference between Bonds and Peer-To-Peer Lending (“P2P”) from some of our individual lenders who already hold bonds in their portfolio. Here are five ways P2P compares to bonds for investors.

Bonds and P2P have a couple of common factors in that both are a debt based sources of financial investment, and both allow an investor to diversity into different risk / return characteristics from an equity portfolio.

However, despite this similarity both have vast differences...

Structure
P2P The structure of the P2P product is the same as a loan. It is person A lending person B money, which person B returns along with interest at a predetermined time. What makes P2P unique from other loans is that it provides a marketplace that makes the meeting between person A and B easier and more transparent.

Bonds Bonds are a financial security. Therefore they are tradable and their value varies instead of staying fixed. A single issuer (the borrower) issues a bond, which the marketplace can purchase increments of at the time of issue in the primary market. These increments can be traded in the secondary market, similar to stocks or can be held to maturity to regain the principle and interest payments, similar to a loan.

Market and access
P2P The P2P market, though much smaller than the bond market is growing rapidly. This is largely due to the innate efficiency of the P2P model of matching borrowers and lenders at interest rates both are comfortable with, and also due to the ease of access into the market, with users able to set up an account by simply signing up online.

In fact, this ease of access is so pronounced, it prompted Lending Club, a U.S. based P2P platform to issue an explanation about the excess amount of lenders on their platform, where loans are on average fully funded within 24 hours, and has led to them actively reducing investor acquisition efforts .

Access to information is also high, as the list of potential borrowers you wish to lend to is only limited by the number of borrowers on the platform of your P2P provider. Finally, investors can lend in small increments of (as little as HKD 10,000 at Monexo) allowing easy diversification among different loans.

Bonds In comparison, the bond market is larger and more mature, with a history spreading back centuries. Popular examples are War Bonds, issued by the US Congress to fund the War of 1812. In fact, the British Government began issuing bonds (called Consols) back in 1751, which are still in circulation today! The bond market has only grown since then, moving beyond sovereign bonds into the corporate world.

However, don’t confuse size with access. The use of bonds is still mostly dominated by institutional investors such as funds. In fact, only certain types of corporate bonds are open to individual investors, while others can only be bought by qualified institutional buyers (not the average Joe). Bond tickets can be large too, with ticket sizes in excess of HKD 500,000 not uncommon, limiting access for smaller investors, or reducing their ability to diversity effectively.

Access to information is also more limited, as a centralized list of accurate trading levels for corporate bonds is not easily attainable without access to brokers, which may cost a fee, or access to financial software such as Bloomberg terminals.

Return
P2P The simplicity of measuring P2P returns is fairly straightforward. A one year loan of 100,000 with a 10% interest would earn 10,000 in interest at the time of maturity.

Bonds A bond has the same 10% return if it is bought at par (for the price of 100) and is held to maturity. However, as bonds are traded securities, their price fluctuates.

Therefore, a bond paying the same 10% interest with a year to maturity would return a different amount if it is bought at a price of 95, or a price of 105. Thinking about it simply, if you paid 95 for something priced at 100 you are really getting more than 10% return. That's why the term for prices below and above 100 in the bond world are call “discounts” and “premiums”.

Risks
P2P There is a default risk with any kind of debt if the borrower does not repay. P2P and bonds are no exception.

For P2P, the risk profile is largely covered by credit analysis summarized by the P2P company, which looks at the existing leverage of the borrower, the amount and duration they wish to borrow for and credit union reports. The platform then compares this to things like their assets, earnings and proposed use of borrowed funds. All of this is streamlined and reported to the lender by the P2P company, allowing them to assess each borrower individually.

Bonds There are similar tools with bonds, which often having a professional credit rating to help gauge risk. Credit analysis of the issuing company and related businesses / units should also be done to determine the likelihood of default.

However, there are other risk factors that make bond risks unique.

The seniority of your bond should be considered, as a default that results in the liquidation of a company will receive payment after more senior debt in a company’s capital structure. For example, bonds typically rank senior to shares, though would likely be junior to bank debt. There are also ranks within the capital structure for bonds of different types of seniority. Other risks are present too. For example a mining company with a solid credit profile might default if political or environmental factors result in their assets being seized or destroyed - something that might not show up in your credit analysis! M&A activity might effect the risk profile of that company too if large and aggressive acquisitions and investments are made with uncertain returns. Currency fluctuations may affect cashflows for multinational companies with inadequate hedging, another risk factor you should consider.

Analysis
P2P P2P analysis is gaining traction in large part due to the simplicity for lenders. They look at the credit profile on a case by case basis for each individual borrower and can lend if they are comfortable with the risk / return trade-off of the loan and borrower. The foundations are built on simplicity and transparency.

Bonds Bond analysis is more complex, as the credit analysis will require going through financial statements and bond prospectus documents. However, there are other factors to consider. For example, comparing bonds across geographies may require the use of Credit Default Swap (CDS) rates, and different currency bonds might need to be currency swapped to compare them like-for-like. Bonds of different types can be compared on a yield, or spread to treasury basis, though different tenors might require the use of Z-Spread analysis. Many high yield bonds have optionality such as call options, leading to some investors incorporating option-adjusted spreads. There is also a large derivative market, as portfolio managers use futures to manage duration instead of trading the bonds themselves. All of this is very exciting, though perhaps not the level of analysis you have time for if you are an individual investor, or even if you are an institutional one managing a multi-strategy portfolio.

Conclusion Which of these two debt instruments are best for you? It really depends on your goals and limitations! Getting educated on both the complexity of the bond market and the “new-age” P2P market is a good way for you to make the right decisions for yourself.

Author: Shehreyar Jamshed, CFA
Disclaimer: The information in this communication has been prepared without taking into account your objectives, financial situation or needs. As such, it should not be construed as investment advice, nor an opinion on the appropriateness of peer-to-peer lending or alternatives for you. All investment and borrowing decisions should be made individually in regard to your own objectives.