A Tale of Four Loan Markets (2): Peer to Business Lending

And the ORB Market

William Shakespeare, an investor, courtesy Wikipedia

Several years before his death, Shakespeare retired to Stratford upon Avon. He had accumulated a large patrimony of "barns, stables, orchards, gardens, lands, tenements and hereditaments", according to his Will, that he leased for rent. These income-producing assets were not without risk of default, but he knew the leaseholders and owned the properties. Most were not far from his home in Stratford.

 

Shakespeare took a time-honoured route to accumulating capital. In a matter of only a few years, individual savers have been offered routes that bypass the traditional institutions - the banks and official markets. P2P, P2B and the so-called 'mini-bonds'.

 

Peer to Business (P2B) Lending

 

Funding Circle launched P2B in the UK in 2010, since when it has matched loans of 188 million pounds. The procedure for lending funds is similar to Zopa's P2P (see http://thejoyfulinvestor.blogspot.co.uk/2013_12_01_archive.html).

 

However, unlike the main providers of P2P, Funding Circle does not have any fund to protect lenders from default. Instead, the intermediary recommends spreading your loan over many borrowers. It provides a table of expected returns.

 

Credit rating	Net interest before Default %	Estimated Annual Default Rate	Annual fee	Estimated Annual Return %
A	6.4%	0.6%	1%	4.8%
A-	8.1%	1.5%	1%	5.6%
B	9.1%	2.3%	1%	5.8%
C	10.1%	3.3%	1%	5.8%
C-	11.7%	5.0%	1%	5.7%

 

According to Funding Circle, the average return for the saver is 5.7%. The interest rate that the borrower pays is between 1 and 2% above the rates quoted in the left-hand column of the table, with the difference going to the intermediary.

 

Typical borrowers are:

 

·         Accountants requiring funds for expansion. 30,000 pounds for 4 years, with an 'A' credit rating paying an average interest rate of 7.9% p.a. to Funding Circle.

·         Ecommerce expansion with a 'B' credit rating, 100,000 pounds for 3 years, paying an average interest rate of 10.6%

·         100,000 pounds for 5 years for a Sushi restaurant with a 'C' credit rating, paying an average interest rate of 10.6%.

In all three cases, the directors guarantee the loan, but there is no lien on any assets held by the business. The credit ratings come from Experian and Equifax, who are private enterprises that sell credit checks for profit.

 

Unlike Shakespeare, lenders to Funding Circle do not own any assets. The capital value of the loan is as much at risk as the income it provides. Funding Circle's estimate of the risk of default is based on a very short period of operation, and the credit ratings must be taken with a pinch of salt.

 

However, the government is so enamoured with alternative ways of funding small and medium enterprises (SMEs), that it is financially supporting P2B. Some of the loans are matched to 10% by the government. Unfortunately for the lender, this does not include any guarantee of the sums loaned.

 

 

Funding Circle, like the P2P intermediaries Zopa and RateSetter, is a small concern. It has a net worth of 6.5 million pounds and it has launched a similar business in the USA. In the event that Funding Circle fails, lenders are promised the support of Link Financial Outsourcing Ltd, a debt collection agency. Lenders are told that Link may not charge them more than 2% for its services, but it is impossible to know how much of the loans made through Funding Circle would be collected. And Link itself is a small company with a net worth of 5.2 million pounds.

 

Order Book for Retail Bonds (ORB)

 

The London Stock Exchange launched a new market to sell UK government (Gilts), supranational, local government and corporate bonds to retail investors in February 2010. Although retail investors have always had access to Gilts, Eurobonds and Convertibles, ORB offers an easier and cheaper way of buying bonds and in smaller quantities - as low as 1,000 pounds initially and 100 pounds thereafter. Individuals can now buy these securities online at their usual broker. ORB has also encouraged smaller and less credit worthy businesses to sell bonds to the public.

 

ORB had a retail turnover of 11.2 billion pounds in the month of November 2013. The largest single bond was National Grid's 'linker'. It offers 1.25% over the annual increase in the Retail Price Index and it matures 6 October 2021. Coupons are paid half-yearly and the bond is currently priced at 109p.

 

A variety of bonds is on offer. These include fixed rate (or conventional) bonds, floating rate notes, index linked bonds ('linkers'), zero coupon bonds and convertible bonds. And ORB has a liquid secondary market.

 

The Financial Conduct Authority oversees ORB and, as a result, the information available to the public is complete.

 

Places for People is but one of many UK property companies to tap the ORB market. Its prospectus for the bond it issued in June 2011 runs to 92 pages. Moody's gives the bond an Aa3 rating and, at the current price of 106.2, it yields 2.8% to maturity in 3 years time. This is a conventional bond with a coupon fixed at 5% and its maturity date fixed for 27 December 2016.

 

For investors wishing to use the tax shelter of an ISA or SIPP, any ORB bond with a maturity exceeding 5 years is eligible for inclusion. This is a clear advantage over P2P and P2B loans, which are not eligible for an ISA or SIPP.

 

One such eligible bond was recently issued by Bruntwood Investments, a large, private property company.  Its 6% 24 July 2020 bond yields 5.0% to redemption at its current price of 105.7. Although the bond is not rated by any credit agency, it has a charge on Bruntwood's properties. Pieces as small as 100 pound face value (106 pounds) may be bought on the secondary market. Bruntwood may redeem the bond early by paying the higher of par (i.e. 100) or the equivalent price of a 4.75% Gilt maturing in 2020 +0.5%. This would currently be much higher than the price of the bonds. Were Gilt prices to fall, then Bruntwood could redeem the bonds at a lower price. But in this scenario, Bruntwood's bond would also have declined in value on the secondary market.

 

Conclusion

 

 

The ORB bond market offers the individual investor the opportunity of creating a portfolio of bonds that fit his or her requirements. In the secondary market, individuals can invest as little as 100 pounds. Funding Circle's P2B offers better rates to the saver than a bank and, very often, than a bond traded on ORB.

 

Interest rates for lenders/savers	Best bank	Funding Circle	ORB
3 years	2.65%	5.7%	2 to 4%
5 years	3.15%	5.7%	3 to 6%

 

However, Bank interest and ORB bonds (with 5 years duration) are tax-free for ISA and SIPP holders, who may not use P2B. Consequently, for 40% rate taxpayers the alternatives to P2B usually offer better after tax returns.
 

And P2B is a much more risky proposition than ORB:

 

1. P2B loans are for small businesses that might, and do, disappear. ORB bonds are issued by the UK government or large, well-known enterprises whose audited accounts are publicly available. The Gilt and Corporate bond market has a long history.

 

2.  The vetting procedure for P2B is quick & easy and superficial. ORB issuers must prepare a prospectus and the vetting procedure is based on a long experience of bond defaults.

 

3.  P2B loans are backed only by the directors. ORB issuers come with credit ratings by the big agencies and/or are backed by valuable assets

 

4. The companies that organise the P2B market are small and lightly regulated by the Office of Fair Trading. A failure by an intermediary will almost certainly lead to lenders losing money. Meanwhile ORB is part of the London Stock Exchange and it is regulated by the Financial Conduct Authority. However, this does not eliminate the risk of a default on ORB.

 

5. The notional returns on P2B may be overstated, as this is a new market with little experience of loan defaults. On the other hand, for very small sums P2B offers lower transaction costs.

 

6. The secondary market for ORB is very liquid. In the case of P2B, if the borrower is behind on his payments, the lender cannot sell on the loan.