How will Coronavirus impact P2P investors?
We have just experienced an extremely turbulent week in financial markets. Equities fell 7% one day, 10% another, and then US stocks rallied almost 10% late on Friday. This volatility is higher than during the worst of the 2008 financial crisis.
The equity markets have been reacting to the deteriorating economic outlook and uncertainty caused by coronavirus. Measures such as travel restrictions, reduced social interactions, and cancellation of public events will create headwinds for the global economy. The strict measures taken in China, South Korea and Italy may need to be copied by many other countries.
Central banks have cut interest rates in many countries recently, including the UK and US, to try and counter the impact of coronavirus. These measures will help, but we still expect to still see some economic weakness, and potentially even recessions in some countries. This will lead to higher business insolvencies, more loan defaults, and higher unemployment. We also expect that funding will be harder to find for some loan originators.
We expect P2P returns to outperform other options this year
Priority number one for everyone right now is the health of their families, friends and the wider community. We realise that any other topics such as investing are far less important and a secondary concern.
However we know that when there is an uncertain outlook, people quickly focus on the security of their own personal finances. Many investors will be wondering – should they reduce their P2P investments? Should they switch out of equities and into credit (including P2P loans)? Or should they just ‘sit on their hands’, make no changes, and see how things play out?
That decision is something each investor needs to decide for themselves based on their own circumstances and outlook. However there will be one big consideration for anyone considering changing their portfolios – where to put those funds? Bank deposits are an option, and safe, but they yield close to zero. Government bonds have a negative yield in many countries. Equities are extremely volatile and could drop further.
That means that the biggest alternatives to P2P loans are either highly volatile, or offer no returns. We think this type of market environment can actually make P2P loans one of the best investment options available right now. Even with the uncertainties ahead, it should be possible to generate positive returns from P2P, without the downside risks of equities.
However, the deteriorating economic outlook means that it is prudent to be more conservative with P2P loan selection. Below we list the types of loans that are likely to be at most risk from the impacts of coronavirus, and some better alternatives.
These types of loans are most at risk
Unsecured loans to small businesses
We’ve never been big fans of buying unsecured P2P loans made to individual businesses (sometimes called ‘P2B’). That’s because often there is insufficient financial information provided by the borrowers. Frankly, we also don’t have much confidence in the underwriting abilities and experience of the teams running some sites.
We recently reviewed the loans on one European P2P site and saw many loans to companies involved in bars, restaurants, retail, events and trade shows. The outlook for each of these sectors is poor and we would consider these loans at high risk from being impacted by coronavirus.
Loans to self employed people
You can think of self employed people as small businesses with one employee. Self employed people tend to make good money when the economy is strong, but suffer during a downturn. We expect delinquencies on loans to self employed people to increase. This increase will be higher than for loans to people who are employed by companies. Only some P2P sites provide details about the employment status of borrowers, but if they do, we would recommend avoiding loans to self employed borrowers right now.
Loans secured by land
We have often warned against investing in P2P loans secured only by land. The reason for this is because of what we observed during the last financial crisis. When property prices decline, two things happen. Land values can fall dramatically, and become almost impossible to sell, as there are no real buyers. The value of land is extremely volatile because its value is highly leveraged to the value of any completed property that could be sold on that land. A fall of 20% in property prices can lead to falls of 75% in land values, for example. Most of the P2P loans secured by land have LTVs of 40-60% and we think that is too high, particularly in this environment. Land that is most at risk from big price falls is located in less dense areas, such as housing developments on the outskirts of cities and towns. Cheap land (lower prices per square metre) has the most price volatility. Land located in the best locations (i.e central parts of cities and towns) is less volatile.
Loans to some development projects
Coronavirus may potentially impact real estate development projects in several ways. Firstly, construction works may be disrupted, either due to lack of supplies, or because workers are not permitted to attend the site. That is a problem for investors because incomplete projects are worth very little, and there is a risk that developers may abandon a project if they don’t see any prospects of recovering any of their investment. Even if projects are completed, it could take significantly more time than expected to either sell the properties, or to refinance the P2P loans.
This means that developments that are in their early stages, with a long construction period ahead, are particularly risky propositions right now. We have always preferred development projects that involve either renovations, changes of use (such as from commercial to residential), or can be completed quickly. In the current situation it is better to favour these types of projects, as they are much less risky, and the returns available are similar to the higher risk development projects.
Loans issued by weak loan originators
Many European P2P loans are issued with a ‘buyback guarantee’ if the borrower defaults. That means that there is no risk to the investor, unless both the borrower and loan originator default on their obligations. If more borrowers default in the future, that means that loan originators are going to have to buy back more loans from investors, which hurts their profits.
During the financial crisis it became very difficult for weaker finance companies to borrow funds, or raise equity. It is possible we may see a similar situation in coming months.
We have always tried to highlight the importance of selecting the best loan originators. We publish ratings for loan originators found on various P2P sites to help assist investors with this. So far, we haven’t seen a huge number of defaults by these loan originators. There is a risk that could change over the next year. It is more important than ever to stay away from lower quality loan originators.
These types of loans should out-perform
Auto loans (loans secured by vehicles) performed extremely well during the 2008 financial crisis. That is because many people relied on their vehicles to get to their jobs. Falling behind on payments could lead to a loss of their car which could then lead to a loss of their job. It is difficult to know whether any recession or disruptions caused by coronavirus would result in the same strong performance of auto loans. We suspect that it would. If defaults increased, the impact would be manageable for most loan originators, because in many cases the repossession value of the car would be able to cover most or all of the loan balance.
Loans secured by real estate
If we can expect loan defaults to go up, minimising losses from defaults becomes more important. It makes having good quality real estate collateral more important. When borrowers default, it takes longer for investors to get their money back. However if the LTV is not too high, and the asset is good quality, they will usually get a full recovery on their investment. We particularly like loans secured with residential property right now. That’s because property values and buyer demand tend to be less impacted by changes in the economic environment than commercial assets like shops, offices and factories.
Some loans secured on commercial assets could be attractive, even if the economy is suffering. But it is important to be selective. Focus on the loan to value ‘LTV’ (the lower the better) and also the quality of the asset. How old is it? How many other businesses could use it? Is it in a good location?
Loans guaranteed by profitable and strong loan originators
Loan originators that are profitable and have strong balance sheets are much more likely to honour their buyback guarantee obligations in the coming months. Profitable, successful lenders are more able to cope with rising defaults. Larger lenders, with higher levels of capital are also more likely to be able to retain their funding lines, issue bonds, and raise more equity from shareholders if needed.
Super senior investments
What is a super senior investment? This refers to secured P2P loans and products where other investors provide additional protection by providing ‘first loss’ protection. Usually this is in the form of a co-investment into a senior loan, which is contractually required to absorb any losses first, if a loan defaults and the collateral is sold for less than the amount of the senior loan. This protection is usually between 5 to 25% of the total amount of the senior loan. These super senior investments are the lowest risk P2P investment options, as investors get protected by having collateral security, and then the subordination from the first loss protection.
Loans in less-impacted countries
It is early days in the fight against the coronavirus. However early indications are that the rates of infection, and potential impact may become higher in some countries than others. This is something that most sophisticated investors will be keeping a close eye on. It is now possible to invest in P2P loans from many countries around the world, often with very short maturities of only 1-2 months. If some countries are heavily impacted, and some less so, it would make sense to shift portfolio allocations towards less affected countries (assuming that quality loan originators can be found in those countries). It is far too early to say whether this prediction is accurate, but it will be important to monitor the situation closely in the next few months.