A 15% Yield Does Not Equal A 15% Return: A Cautionary Note About High-Yield Bonds and Peer-To-Peer Loans

Many new investors are attracted by the interest rates offered by high-yield bonds. With the advent of peer-to-peer loan marketplaces, investors can lend money at very high interest rates to borrowers. It is common to see peer-to-peer loans have eye-popping yields of 15%, 20%, or more. An investor may look at these yields and think that these instruments are better than stocks, which might have expected returns of only 7-8%.

This article will explain why a 15% yield does not equal a 15% return. While high-yield bonds and peer-to-peer loans can be used as part of a diversified portfolio, they should not replace stocks as the backbone of a physician’s portfolio.

Interest rates

When you purchase a bond or lend money via a peer-to-peer platform such as Proper or Lending Club, you are offered an interest rate. For example, you may loan $100 to someone on Prosper or Lending Club at a 10% interest rate. This means that the borrower promises to pay you back your $100 over time, with interest.

The most important word here is promises. The borrower promises to repay their loan, but there is no guarantee that they will pay back the money to you. They may fall behind on their payments, and sometimes they stop making payments altogether.

As a creditor, you can take steps to get your money back, but the borrower may seek bankruptcy protection and your ability to recover your money may be limited. You may end up with part or none of your original loan.

Remember that default is not an all-or-nothing deal. When a company goes into bankruptcy, you are typically able to get a portion of your money back. It may be something small like ten cents on the dollar, and sometimes you can get 90 cents or more back of your money.

Bonds will often continue to be traded even after a company goes into bankruptcy. At this point, the bondholders begin to hustle and use legal maneuvering to get as much of their money back. This is why high-yield bond trading is often left to the professionals, as they will have lawyers to help them get their money back when the courts decide who gets the assets of bankrupt companies.

The yield of bonds or peer-to-peer loans takes into account this default risk. If the borrower does not default, then you get a significantly higher return than Treasury rates. However, if the borrower defaults, you lose money. Your expected return ends up roughly being the returns of (risk-free) Treasury bonds, plus a risk premium to compensate you for the risk of borrowers defaulting on their loans.

Takeaways For Physician Investors

High-yield bonds are not necessarily high-return bonds

When you look at the historical returns of peer-to-peer loans, they are lower than the interest rates you see advertised on the original loans. That is because some of your borrowers have defaulted on their loans.

High-yield bonds do offer higher expected returns, at higher risk

Because you take the risk that you may not get paid back on your loan, the returns on high-yield bonds should be higher than the returns on Treasuries, which has no risk of default. Because of this, the expected return on a high-yield bond of the same maturity is higher than that of the equivalent Treasury or investment-grade bond.

You need to diversify when you buy high-yield instruments

Just like with stocks, you need to diversify when you buy high-yield bonds. Each individual bond could return the full yield or be worthless (if they default). But if you buy a basket of hundreds or thousands of loans, the default rate of your portfolio approaches the expected default rate. Diversification lowers the volatility of your high-yield bond portfolio.

Credit card interest rates are high for a reason

Many people complain about the exorbitant rates banks charge on credit card loans. You routinely see interest rates of 15%, 20%, or higher. However, just like you won’t make 15% if you purchase a bond with a 15% yield, the banks don’t make 20% interest when they make credit card loans. Many of their borrowers will go bankrupt and never pay off their credit cards.

Don’t get me wrong, banks make billions of dollars on credit cards. But for each individual borrower, the bank is taking a risk that the customer will never pay off their credit card.

Refinance your student loans (if you’re not going for public service loan forgiveness)

The interest rates on student loans are higher than the expected default rate of student borrowers. This is especially true for doctors. That is why many companies will offer to refinance your student loans at a lower interest rate than you are currently paying. You should take advantage and refinance your student loans if you are not going for public service loan forgiveness (PSLF).

Conclusion

When looking at bonds or peer-to-peer loans, you always need to remember that yield does not equal return. Bonds and peer-to-peer loans may be good investments in certain situations, but making a comparison of yield with expected returns in other asset classes is an apples-to-oranges comparison.

What do you think? Have you invested in high-yield bonds or peer-to-peer loans? Were your actual returns less than the stated yield when you initially invested?