Definitely, take advantage of the fractionalisation of loans and go for maximum diversification. Lending club history shows that you need to hold at least 100 different notes and no loan should make up more than 1% of your portfolio. Otherwise, returns will be more volatile and are more likely to be negative. It’s fine to start small, but try to get up to 100 in the first year.
Choosing Risk Grades
First, I wanted to see how the interest rates and default rates at Harmoney change across the risk grades. The interest rate charged to customers can be broken down to an expected default rate, a service fee and the Net Annualised Return or NAR which is what’s left for the investor. This is how loans are presented in the marketplace. This graph shows the three components adding up to the published interest rate charged to borrowers.
The blue line for NAR shows a positive relationship between risk and return. The kink in NAR at F5 does draw attention because it has a lower predicted NAR than F4 but is higher risk. Default rates are estimates only, so F5 loans might actually perform better than expected and outperform F4, but I still wonder if investors are being adequately compensated for the risk in F5 loans. Personally, I am not investing in any F3-F5 loans so it’s not a worry for me. We won’t know if these default estimates are accurate until Harmoney publishes actual default rates.
Although we have no idea how the credit processes and grading systems between Lending Club (USA) and Harmoney compare, it’s worth looking at the historical results. First the entire history of Lending Club.
As you can see, the NARs (coloured bars) don’t differ very much between the C and F+G grades. The NAR doesn’t really go up much as risk increases. Should you be indifferent regarding credit grade, or target a specific area? I personally try to hold fewer of the higher risk loans because I feel that in an economic downturn, these are more likely to default.
It is worth exploring the Loan Statistics page at Lending Club to get a feel for how loans there performed. For example, grade F+G loans issued in 2007 returned -9%. Was this due to poor economic conditions, a poor credit model (because Lending Club was brand new), or some other reason?
My Harmoney Porfolio
Thirty credit grades are just too many for me to try to target specific grades to choose to invest in. I’d be waiting ages for a particular grade to appear on the marketplace.
This is the actual outstanding principal in my account for each of the thirty credit grades. It does look very messy. I don’t use this graph. Instead, I’ve grouped the thirty grades into ten deciles.
Ahhh! Much nicer looking. Within a decile category I’m indifferent between grades.
I’m trying to target those loans in the middle that should have better returns than the low risk A grades. I also mentioned earlier that I’m avoiding the riskiest decile, F3-F5. I want to see how those loans perform in a downturn before investing. I’m currently targeting an average of a C2 or C3 grade.
I guess this is how I’m cautiously testing P2P lending. I want to see some history behind Harmoney’s credit grading abilities before funding the riskiest loans.
Choosing the loan term
Lots of new investors wonder how they get their money back. I think it’s best to remember that investing in a loan directly pays differently from bonds and term deposits. The monthly payments are both interest and principal (like most home mortgage payments) so your money is returned gradually and it may take 36 or 60 months to get it all back. Borrowers have no prepayment penalties so they may pay you back faster than expected. I don’t see this as a negative because the funds can be easily reinvested.
Investors’ money is locked in until it is repaid by the borrower. There is currently no market for selling notes to cash in early. For this reason, I don’t think it is a good idea to try to invest large sums or redeem large sums at once (like a traditional bond or term deposit). If that’s what you need, this may not be for you. It is much better to drip feed the money in over the long term, reinvest and then take the cash flows later on. You are able to withdraw the cash in your account at any time.
Initially I had the thought that I should lean towards 36 month loans with the logic that the borrower had actively chosen a shorter term, has the ability to make higher monthly payments and thus may have a firmer financial footing. However, I have no evidence of a difference. 60 month loans do pay more interest over the life of the loan and require less effort to reinvest, but they don’t pay at a higher rate per annum. Assuming the cash flows are reinvested, the 1.25% service fee takes a bigger bite of 36 month loans than 60 because the principal is being reinvested more often or at a faster pace. The 1.25% stretched over 5 years is less per year than 1.25% over 3 years. The difference is pretty small however.
Based on these assumptions, I’m not favouring one term or the other and I’m investing in both. For me, I am investing money I don’t need for more than five years.
So, how are you using the Harmoney platform to achieve your goals?