History shows that bonds and equities aren’t necessarily the best investment options in a rising interest rate environment
The last rate hike cycle in the US was more than a decade ago. The Fed began raising rates in June 2004, continuing until July 2006, anticipating a housing bubble. The Fed Funds Rate began at 1% in 2004, before peaking at 5.25% within two years. During the rate hike cycle, bonds plummeted and stocks sold off, followed by a long rally, resulted in significant market volatility. Meanwhile US consumer credit cards’ interest rates soared.
The positive correlation between consumer credit and the Fed rate is because consumer credit generally amortises monthly and the principle paydown can be used to reinvest into new loans which is originated at the prevailing interest rate. This feature is unlike commercial loans and bonds, which tend to be fixed-rate instruments, repaid in a single bullet at maturity.
Fed Funds Rate, US 10Y Treasury and US Credit Card Interest Rate
Source: Bloomberg
Fast forward to today, the Fed has raised the benchmark rate seven times since December 2015, and economists are expecting two additional increases before the end of the year.
Why invest in consumer credit?
Rising interest rates have already impacted fixed income and equities. Bonds have become more unstable as they trend towards a bear market with investors reportedly shifting into high-yield bonds, the riskiest sector of the credit market. Falling bond yields had forced investors to move into stocks, but the equity market has shown signs of high volatility this year. In recent months, concerns have risen over elevated valuation levels.
On the other hand, amid full employment and robust economic conditions, the US consumer lending macro environment is positive. The unemployment rate and the household debt to income (DTI) ratio are early indicators of consumers’ credit health, and historically have demonstrated a near perfect correlation to delinquency. Currently they, and the credit card delinquency rate, are at a decade low,indicating strong credit repayment capability by consumers in the US.
US Credit Card Delinquency Rate, US Unemployment Rate and US Household DTI Ratio
Source: Bloomberg
How to access this new asset class?
Consumer lending is a US$3.8 trillion industry in the US market. The stability of its returns and its ability to reduce overall risk and reduce volatility in an investment portfolio has led big names such as Soros and Blackrock to venture into the asset class.
Access has never been easier. Since 2002, US marketplace lenders such as Lending Club have digitized the borrowing experience via online platforms. These lending platforms offer a lower borrowing rate than traditional banks, which have costly branch networks and overheads. As a result, borrowers have been enticed to consolidate their credit card balances using marketplace platforms. Many fixed-income funds are buying assets from these platforms, given their attractive and stable returns. Analysts project a $1 trillion addressable consumer credit market for marketplace lending platforms (excluding mortgages) and estimate loan origination volumes could reach $90 billion by 2020.
What are the returns?
While equity returns tend to be higher than bonds in a rising rate environment, market volatility caused by factors ranging from US-China trade tensions to Brexit meant that investors holdings stocks couldn’t be assured of consistency in yields. Based on data from the Lending Club, an investor who bought a loan portfolio initiated in the first half of 2017, will receive an annualised return of close to 8%. In fact, between 2008 and 2017, all vintages had provided positive returns, including the global financial crisis period. The average gain from 2009 to 2017 was close to 8%. The higher market volatility of bond and equity investments is evident when compared with the Orchard Index, which measures the performance of online lending to US consumers.
Average Return – by Vintage Year
Source: Lending Club, FinEX Asia Investment Limited
The Volatility of Orchard Index, Bond Market and Stock Market Indexes
Source: Bloomberg, Orchard Index, FinEX Asia Investment Limited
