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As growth in developed economies slows and higher central bank rates start to bite, investors looking for portfolio diversification and attractive returns could consider a relatively little-known, but high-quality asset class: Household loans. Tonko Gast explains.  

Within the broad household loan asset class, we focus on loans to higher income households who typically use the money to pay off more expensive debt they have run up, or for a home improvement, a car or other large expenditure. They’re typically not for consumption. We source most of the loans for our portfolio from the US. The rest is from Switzerland, France and Spain. 

Household loans generally have a three to five-year maturity. Monthly amortisation means the loans are paid down to zero over the term. This amortisation is what’s attractive: the duration profile is short relative to other private credit asset classes or even other publicly listed corporate bonds.

Such a short duration profile makes the mark-to-market volatility low, typically at less than 1% a year. Even when yields go up – as has been the case recently – the mark-to-market adjustment on the asset class is limited to about -3.5%. For other fixed income asset classes such as corporate, senior or leveraged loans, the mark-to-market can be as high as -15%, as we have seen recently.

We should also note the monthly payment of both principal and interest on household loans generates liquidity, unlike with other credit assets where you may have to wait five or seven years to get the principal back.

Predictable performance

As an asset class, household loans has some correlation to other short-duration assets historically, but almost zero correlation to equities or corporate bonds whose performance is typically more volatile. As for its sensitivity to the economic cycle, this is typically lower than for many other asset classes, while coupons are typically higher.

We see the performance of household loans as predictable. It has been a straight line – in US dollar terms – we have seen no monthly negative returns over the last three years on our portfolio, even with the pandemic, the war in Ukraine, inflation spiking and interest rates rising.

In all fairness, in benign periods, it can underperform asset classes where the absolute yield might be higher, but in more volatile or recessionary periods, such as the period we now appear to be heading towards, this asset class can be expected to outperform. Our current estimate is for a projected annual return in US dollars of around 9% (before costs and after loss assumptions).

Tighter credit conditions can favour better quality loans

If we look at the US macroeconomic context, where the biggest part of our household loan strategy is, we see tight labour markets and an unemployment rate near 50-year lows These are positive signs for the household (loan) sector. We believe the higher-income earners whose loans we target in this strategy are in a good spot because they benefit from tight labour market conditions.

As an example, the average income of the earners whose loans we were buying up until the middle of last year was about USD 100 000, while the US median income is around USD 40 000. Over the last six to nine months, as official rate rises have continued, already tight credit standards have been raised further. The average income of the borrowers is now USD 140 000, and yields are 3% higher.

This is typical of the cycle: As credit tightens, you can find better quality loans.  

Reacting to a possible hard landing

Should the US economy suffer a hard landing and the unemployment rate rises sharply, we would have to add roughly 1.5% of incremental losses to our current credit loss expectation on the asset class of around 2%. That would cut our expected gross annual return from about 9% to around 6.5%.

Keep in mind though that in a hard landing, other asset classes might suffer more. In the corporate bond segment, we could see mark-to-market losses four times higher and credit losses two times higher. That would eat through the current yield in this segment.

We should note that the volatility in household loan defaults over an extended period is about half that of low and high-yield bonds.

If a hard landing scenario becomes the base case, we would use the cashflow from interest and amortisation payments to buy into even higher quality credit.

Its predictability, low volatility and low correlation should make this asset class an appealing option in a period such as we are in now.

This article is an adapted version of a recent Talking Heads podcast with Tonko Gast.