Why We Have Focused On Frontier Market Equities
When investing in frontier markets, we usually focus specifically on investing in equities through the local stock market. The rationale is simple: an investment in frontier markets is usually a play on a country that is early in its development cycle, and aside from private equity that is inaccessible to most, publicly listed stocks are the best way to capture some upside as the economy grows.
Because of this emphasis on capital gains and future upside, we usually gloss over the local bond markets. This is despite the fact that most frontier market stock exchanges often begin with listed bonds – particularly local government bonds, since these are safe and relatively liquid, and it is always in the government’s interest to develop the local financial market. Frontier market government bonds make sense as a diversification tool for portfolios, and usually come with an attractive yield relative to developed markets.
However, buying local bonds still exposes you to currency risk, and in frontier markets where the listed equities are usually the largest companies in the country (and where sovereign risk remains a factor), bonds are not that much “safer” than equities. When you are investing to potentially make multiples on your initial capital from capital gains, even 8%-13% yields on local bonds may not look attractive enough.
The Growth of Alternative Lending
This is where alternative lending potentially flips the script, and offers a fixed income investment that at least makes equity investors reconsider solely focusing on stocks. Alternative lending comprises all the lending that is occurring outside of the established banking system. It includes P2P/Marketplace lending platforms, where lenders and borrowers are connected to each other online, and also balance sheet online lending platforms where borrowers are connected to non-bank lending platforms. Both consumers and small business borrowing is covered under alternative lending.
In the US, alternative lending platforms are relatively mature and many are publicly listed: Lending Club, Prosper, OnDeck, and Elevate to name a few. Because they generally focus on subprime borrowers who would not be able to get bank loans, yields are generally higher than bank loans, although defaults are much higher as well. However, as more money has entered this space, returns have fallen and many of the platforms are still struggling to deal with high defaults and customer acquisition costs.
In emerging and frontier markets, alternative lending has taken off in the past few years with loan volumes more than doubling every year. This is because local banks are slow-moving, and the financial infrastructure in those countries are not developed enough to cater to a growing middle class. In markets where banks often require extensive documentation and credit histories, and loan processes are still manual, a lot of the population remains underbanked and have no conventional means of accessing financing.
Returns That Make Equity Investors Take Notice
Alternative online lending platforms have stepped into this market gap by connecting borrowers and lenders without needing to go through the bureaucracy at a bank. Due to demand for loans still outpacing supply, and the risk of often unsecured loans, yields are also much higher. While government bonds may not look attractive at around 10% yields, alternative lending platform yields of 20-30% suddenly look compelling.
However, not everything is rosy here. Defaults are a real cost to a investors’ bottom line. Many platforms advertise returns that have been inflated through financial wizardry, either through survivor bias (ie. not including loans that have defaulted in returns calculations) or using extreme yields as representative of entire portfolios. Similar to investing in stocks, proper due diligence needs to be done before investing on a platform, and even then we would advise you to start slow. Almost every country will also have withholding taxes charged on interest, similar to capital gains and dividends taxes charged on equity/bond investments.
But given that institutional investors have yet to take notice of this new market, yields remain healthy. As a diversification and cash management tool, putting money to work on alternative lending platforms could be an attractive option for any emerging and frontier market investor.