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Regulated P2P Lending v. Bonds? Factors retail investors must consider

Sep-23-2022


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The last two years have been a roller coaster ride for investors across the globe with varying degrees of ups and downs.

At the very least, it has yet again reminded investors of a very crucial lesson, portfolio diversification.

With a few years of perpetual positive returns from stocks and the newfound crypto market, investor sentiment was at an all-time high. However, things have now changed and even millennial investors who are typically known for their risk appetite are looking for safe and stable fixed income investments.

When it comes to fixed returns, bonds have been the all-time favourite for decades in part due to limited options. With new investment avenues becoming accessible to average investors, it is now a fair question to ask, are bonds still worth it? And how is the RBI-regulated P2P Lending emerging as a challenger?

Let’s take a deep look at how these two promising fixed-income investments fare against each other, especially in the current market scenario.

 

What are bonds? And How do they work?

Bonds are a way of raising capital by private corporations or government-owned ventures. For private corporations, we have corporate bonds, and for government entities, we have government bonds or securities (popularly called “government securities” or “G-Secs”).

A bond is a debt instrument. Businesses and governments issue bonds to raise capital. In exchange, they give the promise to pay the principal amount, plus, an interest rate, more or less like bank loans.

Bonds have been a favourite for investors for a very long time. This is because they give you a steady, regular return, and a secured promise to return the principal amount once the specified tenure is over. They are reliable and are usually rated by regulated rating agencies. They are however not entirely risk-free with unlisted corporate bonds defaulting often. In 2021 domestic companies defaulted over INR 5700 Cr.

Bond returns depend a lot on the risk associated with them. While rating agencies do indicate the creditworthiness of the issuer, sometimes higher rates lure investors to high-risk bonds, that end up defaulting. Not all bonds are secured and not all have collateral backing.

However, bonds are also seeing reduced returns. You can now expect, anywhere between 6-12% annual returns on bonds. And this varies with the type of bond you pick. Higher the risk, the higher the return.

Rising inflation is yet another critical factor in bond investing. As a response to soaring inflation rates, governments tend to increase interest rates to bring down the money supply in the economy. This has been an adverse impact on the value of the bonds you hold. This is called the interest rate risk of bonds, or duration risk. It depicts the sensitivity of a bond’s price to a 1% change in interest rate.

Typically, long-duration bonds fall somewhere around 5-6% for every 1% increase in interest rates.

Even popular and high-rated bonds sometimes end up turning their backs on the lenders. DHFL once used to be a favourite for bond investors, but it ended up defaulting on over Rs 1500n Cr.on bonds.

PSU bonds, touted to be one of the safest and most stable fixed-income sources also have a bit of a history of defaulting on lenders’ money. In September 2019, BMTC or Bengaluru Metropolitan Transport Corp, a State government PSU was rated a defaulter on accounts of irregular payments to lenders. PSU banks are often regarded by experts as being a risky bet.

Bonds also have a high ticket size and a fairly long maturity period. Traditionally bonds have been accessible to only high-net-worth individuals and fund houses offering bond funds, due to their high minimum investment amounts. Even now, when several bond platforms are democratizing the asset for average investors, high-rated bonds are still priced anywhere between 2 to 50 lakh Rupees, making it difficult for small retail investors to get in.

 

P2P Lending: What is it? And How does it differ from Bonds?

P2P or Peer-to-Peer lending, as the name suggests is a debt instrument that involves borrowers and lenders getting into loan agreements without the involvement of any third-party financial institution.

It is similar to a bond in many ways. Primarily, they both are debt instruments used by entities to raise funds. They both offer investors steady interest income, paid regularly over a maturity period. P2P lending is strictly regulated by the RBI and only RBI-approved platforms are permitted to operate. The sector was not regulated until 2017-18 and did witness significant delayed repayments and defaults during the first COVID19, not unlike other lending institutions.

The borrowers in the case of P2P lending are usually individuals and smaller businesses unlike in the case of bonds. Additionally, while bonds may or may not be secured/collateralized, P2P lending is always unsecured as collateralization of smaller loans is often expensive.

Regulated P2P lending platforms like IndiaP2P enable lenders to lend out their money to potential borrowers based on a thorough assessment of their credit worthiness. Additionally, the investment is spread across diverse loan fractions to minimize risk. On the other hand, borrowers get a platform to seek relatively cheaper loans. Different platforms focus on different borrower segments and risk mitigation practices.  

Higher returns are seen in the case of P2P lending (in comparison with bonds) due to the unsecured loans being financed and the fact that these go to retail borrowers directly instead of passing via a bank or NBFC.

Banks make money from the difference between what they charge the borrowers and what they pay to the savers in return for depositing their money with them. Understandably, the savers (indirect lenders) get a lower interest payment than what the borrowers actually pay to the banks.

P2P lending provides a mechanism to bypass the middlemen, thus taking out the banks’ profits from the equation, ultimately resulting in higher interest returns for the lenders.

Since the P2P lending ecosystem in India is fully regulated, the regulations also specify exposure limits, tenures etc. making it conducive for retail investors. You can invest smaller amounts for relatively shorter tenures.

Unlike bonds, P2P lending doesn’t have a duration risk and is largely unaffected by changing interest rates over a long time period.

 

Conclusion

Investors must carefully evaluate any investment in either bonds or P2P lending including the risk-reward profile, regulatory status/protections etc.

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