People keep asking me for my thoughts on Lending Club. I finally capitulated last week and read the prospectus and accompanying supplements/disclosures. My thoughts are as follows:
High-risk, high-yield lending isn’t new. Investors have had access to such investments for the last few decades. They’re called junk bonds.
In fact, it may be illuminating to compare Lending Club notes to just such an investment. Let’s use iShares High Yield Corporate Bond ETF (HYG).
(Admittedly, Lending Club notes may offer some feel-good value or entertainment value not offered by lending to businesses. I, however, find it just as fun to lend to a business as to a person. So for this comparison, I’ll assume such value is zero. That may not be the case for you.)
Fees & Expenses
From page 4 of the Lending Club prospectus:
“Prior to making any payments on a Note, we will deduct a service charge equal to 1.00% of that payment amount….The service charge will reduce the effective yield on your Notes below their stated interest rate.”
So, for example, if a note had an 8% yield and every payment was received on time, you’d earn a 7% rate of return.
The annual expense ratio for iShares High Yield Corporate Bond ETF is 0.50%, half that of Lending Club notes.
Advantage: iShares High Yield Corporate Bond ETF.
Diversification
With the ETF, you’re immediately diversified among several different borrowers. With Lending Club notes, you have to do it manually. In other words, diversifying a portfolio of Lending Club notes requires a) more time, and b) more money than diversifying a portfolio of high-yield bonds.
Advantage: iShares High Yield Corporate Bond ETF.
Liquidity
Lending Club notes can be sold on their Note Trading Platform, operated by FOLIOfn. When selling Lending Club notes, you name an asking price and hope to get it.
When selling an ETF, you have that same name-your-price-and-hope-to-get-it option, or you can simply place a market sell order and know that your shares will be sold almost immediately and that you’ll get a price very close to the price of the last trade.
Advantage: I can’t be absolutely certain because I don’t have any data about sales of Lending Club notes, but I think we can safely say that it’s either a tie or a win for the ETF.
Liquidation Costs
FOLIOfn charges a fee equal to 1% of the price of the sale of Lending Club notes.
ETFs can be traded at your brokerage firm of choice. The commission will depend upon that brokerage firm’s commission structure.
Advantage: It depends upon your brokerage firm and upon how much you’re selling. For example, if you use TradeKing ($4.95 commission/trade), and you’re liquidating less than $495 worth of the investment, Lending Club notes win. If you’re liquidating more than $495, iShares High Yield Corporate Bond ETF wins.
Company-Specific Risk (SIPC Insurance?)
If the brokerage firm where you buy and hold your ETFs goes bankrupt, you’ll be covered by SIPC insurance (up to $500,00 per investor). In contrast, per page 20 of the Lending Club prospectus:
“If we were to become insolvent or bankrupt, an event of default would occur under the terms of the Notes, and you may lose your investment.”
Also on page 20:
“We have not been profitable since our inception, and we may not become profitable.”
In short: In addition to the borrower-specific risk, you’re taking on company-specific risk. Specifically, the risk of a start-up company that has yet to show a profit.
Advantage: iShares High Yield Corporate Bond ETF.
Default Risk
Unfortunately, when Lending Club provides default data, they tend to include every loan that has been issued for 45 days or more. As you can imagine, most loans haven’t defaulted by just 15 days after the due date of the first payment. In order to make a meaningful comparison, we’d need data on loans that have gone full-term.
Thankfully, Lending Club does allow you to download a good deal of data regarding their past loan performance. That’s where you can find facts like these (as of 1/22/2010):
- Of loans more than 30 months old, 11.63% of loaned principle is either in default or has been completely charged off.
- Of loans between 27 and 30 months old, 15.71% of loaned principle is either in default or has been completely charged off.
- Of loans between 24 and 37 months old, 18.49% of loaned principle is either in default or has been completely charged off.
On the other hand, as bad as those default rates appear, they should be accompanied by a few caveats:
- They occurred during a significant economic downturn,
- The sample size (in terms of time covered) is quite small, and
- The default rates for Lending Club’s highest-rated notes are much lower.
Advantage: Neither. There still isn’t enough data to say either way.
Interest Rate Risk
According to Morningstar, the average effective duration of bonds included in iShares High Yield Corporate Bond ETF is 4.25 years. They don’t list the average maturity, but by definition it must be longer than 4.25 years.
The maturity of every Lending Club note is 3 years.
Advantage: Lending Club. Due to their shorter maturity, the market value of a Lending Club note should fluctuate less dramatically than the market value of iShares High Yield Corporate Bond ETF as a result of changes in market interest rates.
Summary
To be clear, the above comparison is very back-of-the-napkin. Because of their high overall default rates, I’ve compared lending club notes to junk bonds. However, a more meaningful method would be to compare each grade of Lending Club notes to a different bond ETF. (The idea would be to match up each grade of notes with an ETF that invests in bonds with similar historical default rates.)
Unfortunately, as I mentioned above, sufficient data does not yet exist for such a comparison to be made.
As it stands right now, I’d categorize Lending Club notes as short-term, high-risk debt that’s difficult to diversify and that carries somewhat higher expenses than I’d like. Entertainment/feel-good value aside, I don’t see much purpose for Lending Club notes in most portfolios.
Of course, a few years from now, the data could prove me wrong.
January 25, 2010 17 comments
Thanks for reading!
