Stressed Out: Lending Club Shows That Main Street Fears High Yield Debt Too

 | Feb 01, 2016 | 8:45 AM EST  | Comments
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This article is part of a Real Money series on 20 companies investors should consider adding to their distressed watch list.

Ask any person on Main Street if they are worried about the corporate bond bubble bursting and you are likely to be met with blank stares. While the nuances of fixed income are lost on many outside of the finance world -- and admittedly, many within it -- there are signs the worries about high yield debt are reaching Main Street.

Last week, Lending Club submitted a filing with the Securities and Exchange Commission, which listed the new interest rates it was assigning to its loans. The rates on higher quality loans fell by three basis points, while the rates on lower quality loans rose by 67 basis points, according to analysis by Compass Point Research & Trading, which was initially reported by Bloomberg.

In its filing, Lending Club (LC) said interest rates assigned to loans could change for a variety of reasons, which include: "current and projected credit performance, balance between supply and demand, macroeconomic indicators and expectations, underlying federal funds rates and competitive environment."

Lending Club did not elaborate on the reasoning behind this change, but Michael Tarkan and Andrew Eskelsan of Compass Point Research & Trading provided their own hypothesis to Bloomberg.

"We suspect it could be related to recent disruptions in credit markets and investor fears around underlying personal and auto loan credit as overall sentiment remains under pressure," Tarkan and Eskelsen said. They also said that investors may be seeking higher rates to compensate for potentially higher default rates.

Lending Club is a San Francisco-based peer-to-peer lender. It also provides loans for small businesses, but when it originated, it focused on providing loans to individuals for such things as debt consolidation, medical bills, and auto loans. Borrowers with good credit sometimes found that the rates they got through Lending Club were lower than rates they'd find at a bank, while borrowers with poor credit found that they were able to get loans -- albeit at high interest rates -- that banks would usually deny.

Its business is one that can generally be understood by anyone who has a credit card or ever applied for a bank loan. As such, its recent move to raise rates on riskier loans can provide a window into why the broader market is worried about high-yield corporate debt, and why Real Money has singled out 20 companies to focus on in its own "Stressed Out" index.

The rise in corporate debt issuance has been attributed to the years of near-zero interest rates by the Fed. Companies found that they had access to relatively cheap credit and they found willing lenders partly in the form of income-hungry investors who were willing to assume more risk in a search for yield. But the party may be ending soon.

Many worry that the bubble will burst, as is the case with all things that grow too quickly. Some of those fears have been confirmed. In December, Third Avenue Management closed one of its high yield mutual funds after facing significant redemptions throughout the year. Many of the assets left in the fund are highly illiquid, low-rated debt issuances that the fund is having difficulty unraveling.

Elsewhere, many energy companies are finding their own balance sheets deteriorating in the midst of low oil prices. In fact, over half of the companies in Real Money's "Stressed Out" index are directly affected by low oil prices. Many of these companies issued debt to fund dividends and acquisitions in happier times and are now finding themselves burdened with hefty debt loads, which are due to mature in the next few years, as well as high interest rates to service debts with later maturities.

Creditors have become less confident in some of these issuances and many of the bonds trade well below par and have yields well into the double digits. For example, a 6.125% note due to mature in 2021, issued by Chesapeake Energy (CHK) is quoted at $26.50, which represents a yield of 42.8%, according to data provided by Thomson Reuters. The price of the issue has fallen sharply since November, reflecting worries about the broader energy market as well as Chesapeake's own difficulties: its credit rating was downgraded by Moody's in December.

If Tarkan and Eskelsan's hypothesis about Lending Club's lenders is correct, then Main Street may be wising up to the risks of high yield debt. There could be more pain to come.

For more on Real Money's 20 distressed companies to watch:

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