Taking advantage of unsecured debt

Two sides of a coin

If you read the last article, you’d be asking, is TGS off his rocker?

Bear with me, I’m not.

From the perspective of the person holding the debt, any form of unsecured debt is a massive, massive inefficiency. It costs a lot. It impacts your credit rating negatively. It has a lot of hidden fees and charges that blindside you. And did I mention how much it costs?

But these very reasons are what makes it profitable for people to lend money without any collateral to hold on to.

In today’s article we’ll talk about what you can do if you want to be part of that party. And whether it’s worth it at all to do so.

First, lets take a look at the landscape. Unsecured debt comes in many forms. The most common ones are:

  • Credit cards
  • Borrowing from friends and family
  • Short term/emergency/payday loans with a payback period that is usually in months
  • EMI purchases of consumer goods

How can you participate in these?

Well, one way is to lend to people in your circle who need the money. That’s a great way to ruin relationships. If you’re doing this at all, do so with the expectation of helping someone out, and not really expecting the money back.

A second way to participate in these loans is when all this debt gets aggregated and packaged into other financial instruments. Firms or people can buy into these, and they do come in with some advantages such as a high yield(or coupon) rate and the dispersion of default risk across a large number of loans.

They also come with a cost - there’s a lot of people that need to get paid before that instrument reaches your hands. Finally, the ticket sizes here might not be small, so the barrier to entry can make these instruments an invalid option for most.

And lastly, they can be opaque and hard to understand - remember the crash of 07? That was because of sub-prime mortgages pooled and repackaged into securities like these, with someone left holding the bag when the market crashed. Those technically had an asset backing them. These do not. Caveat emptor.

A third way is to do so directly through peer-to-peer lending firms. Here, you choose the borrower you wish to lend to and the amount. The term would be pre-decided. Some borrower details are available to have a view on the risk entailed. Some of these platforms also allow taking a position in a pool of loans, blurring the lines between the two options. If you have a surplus of money, a high risk-tolerance and are looking for greater yields than the debt market would give you, these remain a decent option for a fraction of your surplus.

A final way is a variation on the above - instead of people, you lend to firms looking for bridge or working capital loans. Typically, these would be large amounts, have a term of 1-3 months and a decent rate of return. Ticket sizes would be large.

How does one judge these instruments?

The above mentioned platforms give you some key indicators when investing into a person’s debt. You might see some or all of these depending on the applicable privacy laws:

  • Their credit rating. This is the single best indicator of safety
  • The reason for the loan (emergency medical, growth of business, etc.)
  • The number of loans they currently have running (and their amounts) and the number they have taken in the past and repaid
  • Prior defaults
  • If they’re running a business, then what their prior year revenues are
  • If they’re salaried, then what their pay is
  • The proportion of pay that goes into servicing loans
  • Their location, educational background, family situation
  • Average bank balance in the last year

For a firm, you’ll see similarly applicable details about firm health(which is a whole other thing we’ll touch upon in articles about reading financial statements)

All in all, there is a wealth of information that allows you to make an informed decision. My advice would be to invest smaller amounts into a lot of loans to spread the risk out even more.

In closing, unsecured debt offers the risk-tolerant investor a good way to get exposure to high-yield debt. It shouldn’t be your first, second, or even third choice, but if you have a large enough corpus, then it offers a good option for part of your debt bucket.