Since the great financial crisis of 2008, there has been a fundamental shift in the fixed income landscape. Banks have been central to creating credit for consumers and small businesses, driven by their ability to take deposits at low cost and lend money at higher rates. While non-bank credit channels have always existed alongside traditional banking, these channels have historically been small points in the overall economy. However, a new type of lender has emerged to become a significant presence in the market. Initially, they were known as “peer-to-peer lenders” or “marketplace lenders”. Today, these platforms, such as Lending Club, SoFi and Square, are known as “alternative lenders.” These technology-based lending businesses are disrupting the lending markets and taking market share from traditional banks.

Structural cost advantage

Because alternative lenders are not burdened with either the essential infrastructure of traditional banks (they have no physical branches) or the same level of regulatory oversight (banks are typically regulated by the full spectrum of state bank examiners, the FDIC, SEC, Reserve Federal and consumer credit agencies), they are able to offer loans at significantly lower rates. Alternative lenders have been able to use their high operating efficiencies to offer more attractive rates to consumers and small business borrowers, while also providing a superior service experience.

The rising cost structure of banks in the post-Dodd-Frank Act era makes it increasingly uneconomical to obtain small business loans. With few practical alternatives, many small business owners have turned to credit card borrowing, taking on debt that often carries a high and variable penalty rate. As a result, alternative lending platforms have steadily gained market share by catering to this underserved segment and creating cost-effective smaller loans.

Source of Capital for Alternative Lenders

There were two significant early obstacles to the industry. The first was that borrowers want their money fast, but the platforms first had to find willing lenders. The matching process was not conducive to good service. The second problem was information asymmetry between the individual borrower and the individual lender. Specifically, the lender does not know the reliability of the borrower and vice versa. Such information asymmetry can result in adverse selection. Fortunately, financial intermediaries began to replace individuals as providers of capital, purchasing loans from popular alternative loan originators such as Square and SoFi. Today, institutions are the dominant source of financing for alternative loans.

Alternative lenders prefer institutional capital because it makes the loan financing process faster from the borrower's perspective. Institutional buyers typically buy whole loans; in the early days of the industry it could take weeks for retail investors to finance a partial growth loan. And from a strategic perspective, dedicated institutional capital is more sustainable, allowing platforms to grow responsibly.

Institutional investors were able to raise funds by creating investment products such as closed-end “interval” funds that individual investors could use to access the market. These funds are not mutual funds because they do not provide daily liquidity – you need committed capital to get term loans. Instead, they provide for repayment (with typical limits of a minimum of 5% per quarter) at regular intervals (such as quarterly).

This type of financial intermediary can help reduce asymmetric information risk by establishing strong credit standards (such as requiring a high FICO score), performing extensive originator due diligence (to ensure that the culture their credit is strong), structuring payments in ways that can improve performance (such as focusing on fully amortizing loans and using automatic ACH settlements, thus eliminating the choice of which loans to pay off, as with credit card debt) and requiring the originator to purchase all loans that are shown to be fraudulent. They can also require business loans to be paid directly from sales invoices. Additionally, they can improve credit quality by purchasing loans from originators who use social media to confirm information on loan applications. By improving transparency, they also facilitate the flow of capital to borrowers in a more efficient and reliable manner.

Access to alternative credit

Historically, consumer and small business credit risks underwritten by banks were not shared directly with outside investors. In June 2016, Stone Ridge Asset Management launched it Lending Alternative Risk Premium Fund (LENDX). Today, LENDX is the largest established alternative lending fund in the US, with $2.4 billion in total assets under management. This scale offers the benefit of diversification across approximately 460,000 loans (typically three to five year fixed rate loans that fully amortize with a duration of approximately one year (due to prepayments)) and over 14 lending platforms.

LENDX performance

The table below shows LENDX's year-over-year and year-over-year returns relative to one-month Treasury bond returns, as well as those of two alternative income funds— SPDR Blackstone Senior Credit ETF (SRLN) AND Invesco's Senior Credit ETF (NCDs)– and iShares Core US Aggregate Bond ETF (AGG).

Due to the fund's strong performance through 2021, LENDX's assets grew to approximately $2.4 billion. As in this case, in most economic cycles, the economy and strong performance led to a cyclical decline in credit standards. Rising inflation and interest rates in 2022 saw the fund generate below-expected returns, including a small loss in 2023, which was otherwise a good year for other fixed-income assets as rates fell from maximum levels. Rising inflation led to wage growth falling below inflation for two years, an unusual event that contributed to the increase in loan losses.

Alternative lending has a self-healing mechanism

As is the case with all risky assets, alternative lending has a self-healing mechanism that occurs after periods when realized returns are low or losses are experienced. For example, in the case of reinsurance, when losses occurred due to the historic wildfires in California, not only did premiums rise dramatically, but underwriting standards were tightened (such that you can't buy insurance if you have trees within 30 feet of from your house, and all the brush had to be cleared for another 30 feet). Discounts increased significantly (reducing the risk of losses). Hurricane devastation in Florida triggered the same events (increased premiums and deductibles and tougher underwriting standards).

Similarly, the weak returns of 2022 and 2023 led to the outflow of capital from alternative lending which in turn resulted in both a tightening of underwriting standards and an increase in loan spreads. The impact of tightening standards on delinquencies can be seen in the graph below.

In addition, the reduced capital available to lending platforms enabled providers, such as LENDX, to purchase new loans at a discount (instead of first) and negotiate “make whole” agreements that cover some losses if losses of default exceeded a standard. In addition, wages are once again rising faster than inflation, reducing the risk of loan losses.

The performance of the fund in the last months compared to the previous six months reflects the impacts of the improvement of credit quality, the increase of credit spreads and the slowdown of inflation.

Note that the relatively short duration of about one year means that by the end of 2024, about two-thirds of LENDX's loan portfolio is expected to be loans under tighter underwriting standards and with tighter margins. high of 2023 and 2024.

Fund Returns versus Investor Returns

Unfortunately, influenced by recent biases, individual investors tend to be performance followers. This results in them buying after periods of strong performance (missing out on strong returns) and selling after periods of poor performance. The lack of discipline results in what is called the “performance gap,” with investors earning returns that are below those of the funds in which they invest. The chart below shows the performance gap for LENDX investors.

Investor Takeaway

Improving credit quality, along with widening spreads, should enable LENDX to earn a risk premium in the 4-5% range going forward. With Treasury yields around 5%, the expected return on LENDX is now in the 9-10% range. Combined with the other attractive attributes of low volatility (about 2.5%), low duration risk (about 1 year) and almost no correlation with traditional stock and bond portfolio assets makes LENDX an attractive alternative to consider adding to a wallet as a replacement for each of them. stocks or bonds, depending on your risk tolerance.

Larry Swedroe is the author or co-author of 18 books on investing, including his latest, Enrich your future: the keys to a successful investment.