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Why Does P2P Lending Pay Investors Higher Rates Than Bonds?

By Matthew Howard on 10th May, 2021 | Read more by this author

P2P lending often pays better than bonds and there are several reasons for this:

Illiquidity – you might not be able to sell up early

Most people invest in bonds through bond funds, where they can sell their holdings in those fund right away, even though the bondholders (the actual borrowers) have not repaid their debts yet.

A lot of investors appreciate the possibility of being able to sell their investments at a moment's notice, regardless of how the economy is doing – and even if they would have to sell at a loss to do so. These are what's called “liquid” investments.

Investments where early-access features might more readily be suspended (relatively “illiquid”) need to pay a premium in rates to compensate investors for the inconvenience of having to wait for their money back at times. This is the case in P2P lending. Investors continue to earn interest while they wait.

Stability – because P2P has fixed rates and few price swings

In August 2019, the Financial Times found that 25% of all government and corporate bonds in the world were trading at negative interest rates. It cited Deutsche Bank and Bloomberg Finance as the sources.

The price of bonds swing around, usually over years or even decades and nothing like as sharply as the stock market. But it can lead to sustained rallies over long periods or, conversely, long-term real losses for bond investors.

Credit Suisse Global Investment Returns and Sourcebooks – by far the best research on overall bond and equity returns – shows a lot of long down periods or simply disappointing periods. More on that in Peer-to-Peer Lending is Better Than Bonds.

In contrast, P2P lending's returns are stable, enabling much more consistent returns that beat inflation. Therefore expect more consistently good returns. This is partly because of…:

Underwritten prices. (I'll explain.)

P2P lending providers set the interest rates on lenders' behalf, taking into account the risks of bad debts. This is part of “underwriting”.

So, the P2P lending industry, for the most part, doesn't allow investors to compete with each other to buy loans at whatever price they want. If it did, it would drive down the lending interest rates, as the price paid to buy the loans rises above the amount the borrower actually borrowed.

In contrast, that is exactly what happens to bonds. This can lead to bond investors getting an overall return that is considerably lower than the underlying risk in the bonds themselves. The prices most bond investors are paying are not the underwritten prices and they can compete each other towards a real (after inflation) loss.

P2P lending is newer

The P2P lending industry was established in 2005 and has gone through two recessions, while bond markets have been around for many hundreds of years and dozens of downturns in probably more than 100 countries.

While all the types of money lending that is in P2P have been done successfully by banks and non-bank lenders for a very, very long time, this asset class only opened up to ordinary people for the first time in the mid-noughties. For individual P2P investors, therefore, it's still relatively new.

Investors are sensible to be cautious about new investments. The perceived risk of newer investments is higher because positive results are less certain until lenders have learned enough to understand the intrinsic risks and to assess investment opportunities.

And the fact is that so many investment ideas are duds, so you can't simply take a new industry at its word that it's going to deliver. This therefore causes an understandable premium in lending rates.

We've seen this risk premium in action. As P2P lending providers have matured and shown deeper records, their lending rates have typically slipped down from levels that were rewarding lenders far more than they deserved. Lending rates have so far come to rest at satisfactory levels that are closer to reflecting the real inherent risks.

Shorter-term lending

P2P lending is usually shorter term than bonds. While bonds are commonly for 10 or more years, P2P loans are usually from a few months to five years. Early repayments are common in P2P loans and many loans are repaid on a monthly basis. With bonds, repayments are invariably at the end of the bond term.

Since there is inconvenience in more frequently re-lending repaid funds and interest, this needs to be reflected in the loan pricing. Higher rates are also necessary to make the work on assessing very short-term loans worthwhile.

Historical reasons

Since the asset class of bank-like money lending used to be very closed, there has been less competitive pricing on some kinds of lending.

As most money lending is still done through major banks, and since they find it easy to cross-sell loans to their existing banking customers, lending rates for some kinds of loans need to come down in some cases. New competition from the P2P industry will enable this as it grows further.

Fewer eyes

Just as investors want safety of a long-term record, they also want safety in numbers.

There are still relatively few people probing and assessing P2P investment opportunities. 4thWay is one of very few specialist international agencies capable of doing so. A good number of institutional investors, including banks, are also now lending through P2P.

But it's not the same as the bond market. The bond market has many bond investors assessing the strength of bonds. Huge numbers of institutional investors, professional analysts, investment journalists and bloggers scrutinise a lot of bonds and bond funds, and all of them could publicly raise red flags.

The information that many P2P lending providers offer investors and analysts for assessing P2P opportunities is truly excellent. But with fewer people looking at it overall, investors might be looking around and waiting for a lot more voices to come along and say it's all okay. Thus, lenders demand higher rates for feeling less safe while investing outside the larger crowd.

Government bonds pull down average rates

Government bonds have historically been called risk-free. Ridiculous when you factor in inflation, bubbling government debts and even negative bond rates. But certainly they typically pay very low rates. This pulls down the average rate in bonds substantially. Since government bonds make up a substantial chunk of all bonds, it brings down average rates. There's no equivalent in P2P.

Pension funds pull down bond returns

Pension funds are literally forced by governments into buying government bonds, even in quantities that aren't appropriate for their customers. And so they also then pile into corporate bonds to try and balance liabilities during times where rates are very low. At times, this somewhat artificial anomaly can lead to poor returns for investors.

No financial institutions are required to buy P2P debt, so the same downward forces don't exist.

What about the risk of bad debts?

Depending on the grade of borrower, the spread of bad debts is very similar between P2P lending and the various grades of bonds from AAA to Caa-C. Most P2P lending, as with bonds, aims towards the lower-risk end.

Bad-debt results in a portfolio of loans in a P2P lending account – or, better, in a basket of P2P lending accounts – have been easily contained. Read more on that, and more on the differences between P2P lending and bonds, in Peer-to-Peer Lending vs Bonds.