What will happen to the trendy new lenders as interest rates rise?

P2P loans are really just bonds, which means they could soon be in trouble. Diversification is the key to healthy returns.

Few things are certain in investment but one certainty is that the prospect of rising interest rates spells trouble. And anyone investing in the alternative-finance sector and peer-to-peer (P2P) lending in particular should make sure they have a strategy in place to cope.

P2P lending is, in reality, a subsection of the weird and wonderful world of bond investing. Loans to consumers (Zopa and Ratesetter) and businesses (FundingCircle, Thincats, Assetz and FundingKnight) may not be structured as fixed-income bonds (like UK government gilts, say), but they are really just an informal version of a bond (or IOU).

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You lend someone or something money, they promise to pay that money back plus some interest, and then you receive your capital at maturity (you hope!).

There are basically just two things you need to care about as an investor in these IOUs. Firstly, that you get your original capital back in full at maturity. Secondly, that the interest (yield) is paid in full and at a level that rewards you for the risk of lending. This risk of lending has several facets.

Most investors focus on the issuer risk, which is of course hugely important. Lending to a big, established company, for instance, is likely to involve much less risk than lending to a small business. The loan to the large firm will warrant a low yield, the other a higher yield.

Yet issuer risk isn't the only worry. You also need to watch interest and inflation rates. If inflation is low, you might reasonably expect interest rates to be low, whereas an increase in inflation might provoke a rise in interest rates. Yet, it's also possible that this relationship might break down, and that interest rates might start rising independently of inflation. That's where we find ourselves now.

There's not much evidence that inflation is set to soar. In fact many argue the exact opposite that deflationary pressures are incredibly strong, powered by some positives (lower energy and food costs) and some negatives (a great sucking sound that sees Europe imploding inwards).

But I'd still wager like most people who bother to listen to what the Bank of England says that interest rates will start rising in the next 12 months. I don't think they'll rise by much perhaps to 1.5% or even 2%. But rise they will.

We don't know what impact that'll have on the wider economy. Raising rates might help normalise the economy or provoke a sudden downturn. But what we do know is that rising interest rates are bad news for most bonds.

Put simply, rising rates imply falling fixed-income bond prices, as yields rise to catch up with interest rates (why would you buy a bond yielding 3% if a bank deposit paid 4%?).

This sell-off varies, based on the maturity of the bond, ie, the length of time you've lent out the money for. This relationship between maturity, yields and interest rate is captured in the term duration risk'. The sensible bond investor looks to move into assets with shorter maturities, in order to minimise that duration risk.

The P2P survival strategy

All this talk of increased interest-rate risk is likely to have an impact on investors in P2P loans. Currently we have no idea what will happen to the pricing of loans on these platforms' secondary markets ie, those loans sold by other investors before they've matured. It's reasonable to assume that prices might fall as investors anticipate higher yields.

Alternatively investors might sit tight and wait until their loans mature so prices won't change much at all. But whatever happens, there will be uncertainty, and a game of catch-up as investors start to expect higher yields from future products. So a sensible strategy for the more adventurous among you would be to go short' the duration risk.

In simple terms, this means you stop putting money into three to five-year loans, because you don't know what rates will be like over that timescale. Instead, you focus on platforms and investment opportunities where you can put money to work for up to 12 months. I think three main sectors should figure in this short duration' portfolio.

Consumer loans via Ratesetter, which offers a facility to invest for either one month (at 2%) or 12 months (at 3.7% annualised).

Secured lending to property-based businesses via platforms such as LendInvestand Wellesley & Co. These fast-growing outfits specialise in niches such as bridge financing for property developers who are looking to borrow money for a specific project, for say six months.

You should be able to benefit from rates of 3%-4% on Wellesley & Co (for six to 12-month terms) and up to 7.8% on LendInvest. Note that both tend only to lend to borrowers where there's a lot of security in hard assets on the LendInvest platform the average loan-to-value ratio of an underlying project is 65%.

Wellesley & Co has lent out £84m against security worth £137m, and also has a provision fund that currently contains £606,564.

Invoice funding platforms such as MarketInvoiceand Platform Blackoffer very experienced private investors (usually with £50,000 or more) the chance to buy into invoices sold by small and medium-sized enterprises.

These firms typically have a well-known customer and might have to wait up to 90 days before being paid. In order to bring some hard cash in sooner, the companies sell the invoice to a platform for anything from 30 to 90 days, paying 1%-1.5% a month, depending on the risk level of the end customer. If you can keep rolling these loans over to fund the invoices and avoid defaults, you could make a yield of 8%-15% a year.

A 6.5% a year return

If you're looking to invest in either of these last categories you might encounter one practical barrier the initial investment required. Both MarketInvoice and Platform Black only really want the wealthier investor, with £50,000 or more and, currently, LendInvest has a minimum £10,000 investment.

But there are some alternatives. Wellesley & Co allows a minimum investment of £100 or more, and industry leader Funding Circleis also moving into secured, property-based loans.

Another fast-growing platform called Assetzalso offers easy access to both invoice funding and bridge funding to property developers look down their list of current auctions and you'll see a mix of both, with terms varying between six and 12 months.

Six-month terms typically involve a fee of 5%-10% (implying annualised returns of at least 10% a year), and approaching 10% for 12-month terms is not uncommon.

Obviously you'll have to pick your investments carefully, and diversify between borrowers. But Assetz is very focused on secured lending to small businesses. You may remember that in a previous column I mentioned that Assetz had announced a loss on one of their projects, based in Belfast.

A shopping mall failed and investors could have lost a large percentage of their assets, but Assetz has now confirmed that it expects full realisation on the loans within the year the security offered up by the borrower has evidently come in handy.

Add up all these different structures and platforms and it's completely possible to build a diversified portfolio of loans that will give you a range of returns of between 3% and 10% a year.

I reckon you could run an average portfolio of assets over a 12-month period with a blended yield of about 6.5%. That's very attractive for what would be a one-year term risk'. And crucially, you'll be able to slowly move money out of these accounts over the next 12 months into longer-term loans as interest rates start to rise.

Alternative heads into the mainstream

In last month's article I drew attention to the small but fast-growing stockmarket-listed alternative-finance space. Literally a day or two after the article was published, the giant US-based P2P loans platform Lending Club announced it would be seeking a listing in New York, valuing it at around $5bn.

Given the rapturous welcome received by Chinese platform Alibaba, I think it's a fair bet that investors will flock to Lending Club's listing, pushing up the price to quite possibly laughable levels.

That rush will make the valuations put on the existing small number of listed plays even more compelling, not least for London-listed GLI Finance (LSE: GLIF). This Guernsey-based small-business specialist already has a number of P2P companies within its portfolio, including Platform Black.

This week it announced more deals, including investments in several US-based platforms (Credit Junction, LiftForward and TradeRiver USA), as well as a UK-based outfit called the UK Bond Network, and an investment in an African firm, Ovamba.

The sheer scale of all these deals is quite impressive and GLIF is obviously trying to bulk up to become a global player. Worth watching closely, especially as that market cap of just under £80m is backed by an annual dividend yield of just under 10%.

You can read more about alternative finance at my site, www.altfi.com.