Personal finance: The search for yield

In mid-January and with considerable irony, Mervyn King observed that a widespread “search for yield” is now under way that is encouraging investors to buy increasingly risky assets that promise attractive returns. In spite of being responsible for the ultra-low interest rates that spurred this process, he’s right. A lot of money has recently poured into areas such as lower-quality corporate bonds—pushing “junk bond” prices to record highs during January as yields fell below 6 per cent for the first time. Rock bottom interest rates touch us all, so it’s no surprise that investors big and small are looking well beyond bond and equity markets for alternatives that can produce higher levels of income.

Over the past couple of years I’ve looked at a fair number of alternatives and put money into several. The pick of them was solar panels, thanks to the feed-in tariffs that subsidise small renewable energy projects. During 2012, which included the wettest English summer on record, the panels earned a net 7.9 per cent. Of course, the original subsidy on solar panels was too good to be true, so the government cut it twice, by a total of two thirds. However, the price of having panels installed also fell significantly so provided you shop around for the keenest price, it is still possible to earn a decent return from this source that is index linked and tax free—any investor’s favourite words.

Another area that has opened up to private investors is online lending direct to other people and to small companies via “peer-to-peer” platforms that enable anyone to lend even small sums for returns usually in the range of 4.5 to 7 per cent after fees, tax and defaults.

Over the past year or so, these new lenders have gained increasing prominence and it looks like they are now about to move into the mainstream. The government has agreed that peer-to-peer lenders will come under formal regulation from April 2014, which should reassure investors that they are well run and solvent, and there are also plans to lend around £100m of public money to small companies via peer-to-peer platforms in order to speed the growth of these alternative finance providers.

For investors looking to try this out, the first thing to know is that there is no deposit insurance to cover your money and that you are bidding against other lenders to offer mainly unsecured loans to individuals or companies. Among the sites that let you lend to other individuals, Zopa is the oldest and biggest, having handled more than £270m in loans so far. Another, Ratesetter, has an ingenious system that levies a small charge on everyone and pools the cash to cover any defaults. That brings down the headline rate of return but at least it smooths the bumps in the road.

Funding Circle is the biggest lender to companies, with more than £70m lent so far, while ThinCats is a smaller site for lending to businesses that has a much higher minimum investment of £1,000 and is aimed at serious private investors who usually demand 11 to 12 per cent. Several sites have automatic systems that will continuously re-lend your money according to criteria you set. This provides a helpful way of diversifying your risks across a large pool of borrowers and should mean you experience roughly average default rates.

The key question is how high a return you need after fees, defaults and taxes to make the exercise worthwhile, bearing in mind the risks. If the platform fee is 1 per cent, defaults average 1.5 per cent and tax takes 20 per cent of the remainder, a 9 per cent gross return turns into a net 5.2 per cent. If you pay higher-rate tax, that comes down to 3.9 per cent. My own experience of peer-to-peer lending so far has been fairly typical, I suspect—a gross return of 7.6 per cent before fees and tax with a default rate in year one of 1.25 per cent, giving a net 4.3 per cent before inflation and about 1.6 per cent after. Useful but not outstanding.

The great hope among the sites themselves is that they will eventually be able to offer tax breaks to make these returns more attractive to private investors. Once they’re fully regulated, this is much more likely—either by making a certain quantity of lending each year eligible for Isas, or by allowing private investors to write off their losses against their profits before tax, which at the moment would improve returns by about 1.2 percentage points a year.

For investors it’s a new avenue to consider. But as it grows, the risk is that the weight of new lenders’ money will drive down interest rates too far. The peer-to-peer sites are admirable for their transparency and the range of figures they publish, which show average rates have fallen steadily in recent months—with the search for yield now in full swing, peer-to-peer lending could become a victim of its own success.