In financial markets, the term Risk usually equates to the ‘exposure to loss,’ which is measured by decisions we make. In order to measure anything, you need a standard, or a starting point, and for risk it is called the Risk Free Rate. The Risk Free Rate is the return that an investor expects from an absolutely risk-free investment over a specified period of time.
Financial institutions and economists will probably look to Government Debt as their Risk Free Rate, but the man in the street will look to the return received by putting his money in the safest place possible, a bank account. The reason it is thought of as risk free is that banks and building society accounts are covered by the Financial Services Compensation Scheme (FSCS). The government guarantees that money up to £75,000, should anything happen to the underlying bank.
For the average investor, the Risk Free Rate is the best rate of interest that can be earned from a bank account. After searching a well-known comparison site, a current account with no gimmicks or teaser rates attached pays about 0.2% per annum, or the same as the current Bank of England base rate.
So if 0.2% is the base line against which we can measure any other investment then the difference between those returns and the Risk Free Rate is called the Risk Premium.
In Peer to Peer lending, the returns are higher than 0.2% per annum, currently the average gross interest rate according to Alt Fi Data is currently 7.24% per annum. Peer to Peer lending is not covered by the FSCS. This means that investors are receiving c7% p.a. of Risk Premium, so just what are the risks investors are assuming?
Lending of any sort, whether secured or unsecured, involves the risk of default. Exposure to loss due to non-payment by a borrower of a financial obligation when it becomes payable. Default risk is related to the creditworthiness of the borrower and can be broken down into two principal areas of risk:
- Income Risk – when the borrower doesn’t make the regular interest payments as they fall due during the term of the loan; and
- Capital Risk – the borrower doesn’t repay the underlying loan capital in full (or at all) at the end of the loan term.
There are ways for a lender to mitigate these risks, not totally, but to a level where the Risk Premium being paid is commensurate with the level of Risk being taken.
- Income Risk: Understand how the borrower is earning the income which will be used to pay the interest on the loan. Proplend for example, only facilitates loans to owners of income producing commercial property, therefore the rent that the tenant pays the landlord (the borrower) is used to cover the monthly interest payments to investors.The rental income is fully documented and transparent through the lease contract between the tenant and the borrower. The lease details how much rent is being paid, how often, for how long, any revisions or breaks, and if there are any guarantees supporting the tenant.This is usually measured as the Interest Cover Ratio (net income from the property / interest cost) to determine the measure of the borrowers ability to meet the interest payments as they fall due.This along with the financial well being (or creditworthiness) of the tenant, serves as a good guide as to how well the borrower will be able to keep making their regular interest payments.
- Capital Risk: Capital risk can be reduced by having the borrower support the loan with collateral, something that is of greater value than the loan, which can be sold in order to redeem the loan should the borrower default on the loan principal.The most traditional form of loan collateral is a property, it is a hard asset against which a legal mortgage can be documented and registered with the Land Registry. A clear legal framework in the UK means that real estate debt offers high recovery rates from the sale of the secured property.This is usually measured as the Loan to Value percentage (loan amount / value of the property) to determine the measure of the properties ability to meet the capital payment.
Whilst Peer to Peer lending offers the opportunity to earn attractive rates of Risk Premium, investors need to ensure that they are being adequately rewarded for the level of risk they are assuming. One solution, to mitigate some of that risk, is by investing in P2P loans supported by income producing property.