P2P lending: is it time to buy?

In recent years we've seen the launch of several investment trusts that invest in loans made via peer-to-peer (P2P) lending platforms. The allure is obvious they promise investors a tasty yield (5% or more) from investing in a basket of loans to consumers or small businesses.

Investors get the diversification without the hassle of investing in individual loans via a P2P platform themselves. Many very respectable fund managers have bought into the story Neil Woodford and asset managers at Artemis, Invesco Perpetual and Axa Framlington have all invested in alternative finance.

However, self-inflicted woes at American non-bank lender Lending Club where founder and chief executive Renaud Laplanche recently stepped down have taken some of the shine off the story. It's a little early to work out what exactly has gone wrong, but there's been talk of grand jury investigations and investment banks cancelling big securitisations.

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At one point, Lending Club was worth a staggering $10bn as fintech enthusiasts talked excitedly about the big, bad banks going the way of the dinosaurs. Now the share price has crashed from a high of $28 to a recent low of just $3.50.

An inevitable backlash

All that excitement was bound to produce a backlash. Big bank lobbyists are grouching about an uneven playing field between their online rivals and their own heavily regulated businesses. Investors also fear that Lending Club's challenges might be the start of a more general sector meltdown.

Lord Adair Turner, the former boss of the UK's financial regulator, recently warned that alternative lenders would be poleaxed in coming years by a huge wave of defaults from business borrowers. With near-panic hitting the sector, many P2P trusts now trade at big discounts to their net asset value and offer very attractive yields. Is it time to buy?

The doomsday scenario

I have a lot of interest in this sector I write about it regularly for Altfi.com, and I'm also a non-executive director of the GLI Alternative Finance fund. But I've also been around long enough to be concerned that things might get worse before they get better. The yields on these trusts may look attractive, but in my experience, bad news like buses often comes in threes.

Corporate upheaval in one business ruffles the whole sector, prompting more bad news to emerge. Investors start to withdraw their money, causing a liquidity crunch. The short sellers pile in and the downward spiral starts.

If growth continues to slow in the US and UK, that could set things off particularly if the Federal Reserve raises interest rates and triggers a rise in corporate defaults. Also, if share prices in the sector keep falling, pushing yields closer to 10% or above, it would unnerve investors. At that level, fears the dividend will be cancelled tend to outweigh the greed of even the most income-hungry. So if a number of factors start working together, we could see bigger price falls. But the adventurous part of me still thinks this doomsday scenario is unlikely.

Firstly, there is some evidence that Lending Club's woes may have peaked. The share price is back above $4, while other platforms have managed to raise new funds via securitisations. There's no sniff of other scandals in the sector yet.

Secondly, big institutions are still interested in all forms of alternative lending. They realise that banks and non-bank lenders will eventually find a way to co-exist, creating a vast opportunity to lend money to all sorts of people who don't quite tick the boxes for a standard bank overdraft or a mega-cap corporate bond issue. In short, alternative lending won't go away.

Thirdly, if central banks are forced to embark on another series of interest-rate cuts, or money printing which I reckon will happen within the next three years then any high-yielding asset class, particularly proven and trusted ones, will be back in demand.

Finally, I also think investors are being too cynical about the credit models used by the big fund managers. I'd hope that they'll be slowly taking money away from long-duration, five-year loans and moving towards shorter-term lending where the risks aren't so great if interest rates do increase.

Also, most of the lending platforms and the accompanying funds are fairly conservative about their own borrowing levels. So they should be able to survive if markets become even choppier. I've looked at two of the most promising in the box on the left.

Two funds to keep an eye on

So which funds would I focus on? P2P Global Investments (LSE: P2P), the firstdedicated loans fund on the London Stock Exchange, is backed by the MarshallWace hedge fund. It is still the biggest fund by far and has the most to lose if the whole alternative lending sector collapses. That should mean the manager behavescautiously, drawing on all that hedge fund number-crunching expertise to makebetter decisions.

With the discount hovering around 13%, the yield on offer shouldstart to crawl well above 8% over time, and with its bias towards platforms issuingconsumer loans, I suspect the downside risk for P2P GI isn't huge from here.

I'm also interested in a slightly different trust that I've mentioned here before Honeycomb investment trust (LSE: HONY). Honeycomb is also very focused onconsumer loans but not those made by P2P lenders instead, it uses fairly traditionallenders, such as finance brokers. There's also a smaller segment of business loans.

When the fund was first launched at the end of last year the yield was expected to bearound 8% (at the issue price of £10). However, the manager recently said that dueto returns on loans being higher than expected, it'll be more like "10% or greater".Partly as a result, its shares now trade at a premium. It's definitely one to watch.

David C Stevenson has joined the Lifetime Wealth newsletter as income specialist.