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December 02, 2019
Alternative Lending: Why Today and Through the Credit Cycle?
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December 02, 2019

Alternative Lending: Why Today and Through the Credit Cycle?


Investment Insight

Alternative Lending: Why Today and Through the Credit Cycle?

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December 02, 2019

 
 

Against a backdrop of low interest rates and tight corporate credit spreads, investors struggle to find sufficient yield from traditional fixed income. Fintech-driven alternative lending is a nascent, consumer-focused private credit asset class that potentially offers yield pick-up, as well as duration and diversification benefits.

 
 

Emergence of a New Investment Solution

Alternative lending, or marketplace lending, is a relatively new form of private credit. Alternative lending grew out of “peer-to-peer” lending by retail investors at a time when banks had retrenched from traditional consumer and small business lending following the Global Financial Crisis. Today, most alternative loans are funded by institutional investors. Alternative lending takes place through online platforms that use technology to bring together borrowers underserved by traditional banks with investors seeking diversified, low-correlation income streams. These platforms may incorporate machine learning/artificial intelligence techniques in their underwriting, which have the potential to enhance financial inclusion and improve the accuracy of risk-based pricing.

The universe of alternative loans spans unsecured consumer, small business and specialty finance, with consumer representing the largest segment by volume. These consumer unsecured loans often have three- to five-year terms, are fully amortizing via monthly installment payments, and are commonly used for debt consolidation or credit card refinancing.1 Until fairly recently, banks and credit card companies dominated unsecured consumer credit extension, making it difficult for investors to access the sector with pure-play exposure to the underlying consumer credit risk.2 The rise of fintech-driven alternative lending has democratized access to this type of consumer credit risk. We believe this nascent private credit asset class offers a potential solution to one of the core portfolio construction challenges facing investors today: the dearth of appropriately priced loss- adjusted expected yield in combination with moderate duration.

Private Credit Investors Seek Income With Less Duration

Alternative loans provide what we believe is attractive loss-adjusted expected yield, stemming from contractual monthly cash flows. Since alternative loans are often extended on an unsecured basis, expected defaults are generally higher and expected recoveries generally lower than traditional corporate credit investors may be accustomed to. However, we believe that alternative loans offer outsized credit spreads that may compensate investors for the additional risk associated with unsecured lending. Even after accounting for our base-case expected defaults and recoveries, alternative lending’s credit spreads may provide compelling returns both outright and relative to traditional credit alternatives, with significant cushion against principal loss should economic conditions deteriorate and defaults exceed base-case expectations.

Furthermore, since the Fed started hiking benchmark interest rates in December 2015 (and even as it has more recently turned dovish), the average interest rate charged on credit card loans has moved higher at a significantly faster rate than the normalizing credit card charge-off rate (Display 1). While this benefits credit card companies, it is suboptimal for borrowers. In fact, we believe it may generate borrower demand for alternative loans, which, as mentioned previously, are often used to refinance credit card debt into amortizing personal loan balances.

 
 
 
Display 1: Historical Interest Rates and Charge-Off Rates of U.S. Consumer Credit Cards (June 1995-June 2019)
9726315-Chart-1
 

Data as 0f 6/30/2019. Source of historical charge-off rates: Federal Financial Institutions Examination Council-Credit Card Charge-Off and Delinquency Rates on Loans and Leases at Commercial Banks through 12/31/2018. For each period, the charge-off rate is the value of loans removed from the books and charged against loss reserves for credit cards at commercial banks in the UnitedStates. Charge-offs are measured quarterly net of recoveries as a percentage of average loans and annualized.

Source: http://www.federalreserve.gov/releases/chargeoff/chgallnsa.htm and https://fred.stlouisfed.org/series/TERMCBCCALLNS

 
 

The amortizing installment structure typical of alternative loans provides borrowers with fixed monthly payments comprising both principal and interest. These contractual payments, along with any prepayments, may reduce the average duration of alternative loans significantly below the average term of the loans. Indeed, a portfolio comprising a mix of three- and five-year term alternative loans may have weighted average expected loan duration below 1.5 years. As compared to corporate credits with similar or lower loss-adjusted expected yields, alternative lending’s relatively low duration may reduce sensitivity to changes in benchmark interest rates.

In a portfolio context, the driver of alternative lending’s low duration—frequent cash flows comprising both principal and interest, as well as any prepayments—may be used to reduce loan vintage concentration through redeployment of cash flows received from loans already in the portfolio into new alternative loans. Alternative loans amortize quickly. Using historical credit card data as a proxy suggests that alternative loans underwritten within six months of the onset of a recession would be most impacted by the recession.3 Therefore, we believe that seasoning different loan vintages in a portfolio across time through cash flow redeployment can be a powerful risk management tool that may be less accessible in traditional corporate credit portfolios comprising balloon-style repayments of principal only at maturity. Historical credit card data further suggests a considerable lag between trough and peak consumer defaults during and after a recession. This provides time for cash flow redeployment to at least partially reposition an alternative lending portfolio into new alternative loans that reflect changed economic conditions through credit standards and coupons charged to borrowers.

We have emphasized the benefits of alternative loan structures, but we also believe that there is an argument in support of exposure to the U.S. consumer: We believe that consumer credit fundamentals currently compare favourably to corporate credit fundamentals. U.S. corporations and the U.S. government have increased their balance sheet leverage as a percentage of GDP since 2008, even as corporate credit spreads have drifted lower (Display 2), with the spread per turn of leverage standing well below the 10-year average (Display 3).

 
 
 
Display 2: U.S. Corporate Bond Spreads (January 4, 2012-January 4, 2019)
9726315-Chart-2
 

Source: Morgan Stanley Research, Cross-Asset Strategy, Global in the Flow (August 1, 2019)

 
 
 
Display 3: High Yield Credit Spread Per Turn of Leverage (June 30, 2009-June 30, 2019)
9726315-Chart-3
 

Source: Morgan Stanley Research, Cross-Asset Strategy, Global in the Flow (August 1, 2019)

 
 

Meanwhile, U.S. household debt relative to GDP has been much more restrained post-2008. On a debt/ GDP basis, U.S. household borrowings have dropped roughly 20 percentage points from peak levels seen prior to the Global Financial Crisis (Display 4). This stands in stark contrast to the post-crisis evolution of U.S. corporate and government borrowings relative to GDP.

 
 
 
Display 4: Total Debt to GDP by Economic Sector
9726315-Chart-4
 

Past performance is not indicative of future results. For illustrative purposes only. There is no guarantee that the market trends will continue, The statements above reflect the views and opinions of AIP Alternative Lending Group as of the date hereof and not as of any future date.

Source: Data as of January 1, 2019. Source: Federal Reserve Bank of St. Louis https://fred.stlouisfed.org/graph/id=QUSNAM770A,QUSHAM770A,QUSGAM770A,QUSGAN770A.

 
 

Household debt service ratios are hovering near multidecade lows, and the unemployment rate is near a 50-year low (Display 5). Real wages have been rising, and consumer confidence remains elevated. Whenever the credit cycle ultimately turns, we believe the U.S. consumer will be starting from a stronger position than in the run-up to the Global Financial Crisis, offering support for a consumer credit allocation within a well-diversified portfolio.

 
 
 
Display 5: Household Debt vs. Unemployment Rate
9726315-Chart-5
 

Past performance is not indicative of future results. For illustrative purposes only. There is no guarantee that the market trend above will continue. The statements above reflect the opinions and views of AIP Alternative Lending Group as of the date hereof and not as of any future date and will not be updated or supplemented. Please reference the glossary pages in the appendix for the definition of household debt service ratio.

Source: Federal Reserve, https://www.federalreserve.gov/releases/housedebt/ and Bureau of Labor Statistics, https://data.bls.gov/timeseries/LNS14000000, as of June 1, 2019

 
 

Conclusion

Alternative lending has grown rapidly in the past decade, disrupting traditional consumer and small business lending. Stubbornly high credit card rates, coupled with the evolution of consumer preference for transacting online, suggest further growth potential. While the economic backdrop will deteriorate at some point, we view alternative lending as a through-the-cycle credit allocation that could be a valuable long-term allocation within a well-diversified portfolio. We believe that alternative lending is a diversifying private credit allocation offering attractive yield and duration characteristics broadly lacking in traditional fixed income today.

 
 

1 “FinTech Credit, Market Structure, Business Models and Financial Stability Implications”, Committee on the Global Financial System (CGFS) and the Financial Stability Board (FSB) (May 2017).

2 “Reaching New Heights: The 3rd Americas Alternative Finance Industry Report,” Cambridge Centre for Alternative Finance, December 2018.

3 “Marketplace Loans: How Might They Perform During a Downturn?,” LendingClub Marketplace Insights Volume 6, March 2019 

 
ken.michlitsch
 
Executive Director
 
 
 
 

DEFINITIONS

Amortizing: The paying off of debt in set installments on a set schedule. Duration: Duration is an approximate measure of a bond's price sensitivity to changes in interest rates. Unsecured loan: An

unsecured loan is a loan that is issued and supported only by the borrower's credit worthiness, rather than by any type of collateral. Yield: Annualized net interest income as a percentage of NAV.

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