In our previous blog post, we demonstrated how investing in 5-year Prosper Notes can produce higher returns, better credit risk management, more diversification and higher monthly income. In today’s blog, we illustrate how investors can diversify their portfolios by laddering. If you’re seeking a way to reduce portfolio risk while maintaining returns, consider adding 5-year Notes and staggering the maturities of your Prosper investment.
Laddering Strategy for Your Prosper Portfolio
Laddering provides investors a number of benefits including an increase in yield and a potential reduction of the credit risk incurred by a portfolio. In the example we use in our previous blog, what would a 50/50 portfolio of 3-year D & E loans and 5-year A & B loans look like?
The 50/50 portfolio has an estimated yield of 21.82% and estimated loss rate of 8.92%, producing a 12.90% estimated return. Comparing returns to risk, we get a ratio of 1.45 which is almost 46% better than a solely 3-year D & E portfolio. The return-to-risk ratio is a type of coverage ratio that indicates a margin of safety. The 50/50 portfolio offers much more potential coverage, at a cost of lower estimated return by only 2 basis points and 19% longer duration (a measure of a portfolio’s risk exposure to interest rate fluctuations).
Laddering’s benefits to help increase yields and reduce credit risk can be applied across the Prosper platform. Consider another hypothetical example: let’s assume that an investor holds equal dollar positions in all Prosper Ratings of 3-year Notes (currently available across six Prosper Ratings). This equal weight portfolio projects an annual estimated return (yield net of losses) to an investor of approximately 9.85%.
Now consider an equal weight portfolio consisting of all available Prosper Ratings of 5-year Notes, below. This portfolio’s estimated return is 11.60%, or 18% higher than the 3-year portfolio.
Let’s look at the potential results of various laddered portfolios that combine the 3-year and 5-year equal weight Prosper Note portfolios from above. In the example below we assume an investor adds 20%, 35% or 50% of 5-year Notes to their 3-year portfolio to create 3-Year and 5-Year blended exposures of 80/20, 65/35 and 50/50.
Adding 5-year Notes to the portfolio increases estimated returns. Let’s just focus on the middle example, a 65% allocation to 3-year Notes and a 35% allocation to 5-year Notes. For this portfolio we project an annual estimated return of 10.46% which represents a 6% increase over our 3-year portfolio example.
What does an investor give up by adding a 35% exposure to 5-year Prosper Notes? The portfolio’s maturity lengthens from 36.0 months to 44.4 months, an increase of 23%. The duration of the 3-year portfolio is estimated to be 1.6 and for the 5-year portfolio it is estimated to be 2.4. So the 65/35 portfolio blend results in 1.9 year duration, or an increase of 19% over the 3-year only portfolio.
Yet, just like before the return-to-risk ratio improves from 0.99 to 1.47, an improvement of 48%!
More Reasons to Diversify with 5-Year Prosper Notes
Our data also show that investors with more broadly diversified portfolios also tend to generate more consistent predictable outcomes. (See our blog post, “Power of Diversification: 100% Positive Returns with 100 or More Prosper Notes“.)
And finally, data show that borrowers on 5-year loans have not pre-paid as much, thereby minimizing cash drag and redeployment costs to the investor.
Note: Prosper began offering 5-Year Loans in the 4th quarter of 2010.
Diversifying your Prosper investment with 5-year Notes in your portfolio can increase yield, improve coverage of return-to-risk while minimizing cash drag–at the cost of increasing maturity and duration. Given the high likelihood that the investment environment will remain volatile and interest rates low, we think that it behooves investors to take advantage of these Notes to help produce predictable high yield income.
To identify available loan listings with 5-year terms, sign-in to your account and go to Advanced Search, click on “Additional Criteria”, check “Loan term” and then select “5 Year”. To create a portfolio of 3-year and 5-year loans, use Quick Invest and add these criteria to your search.
If you’re new to Prosper and seeking predictable returns and higher yields, open an account today or call us at 1-877-646-5922.
* Based on pricing as of December 8, 2011 for first-time borrowers. Estimated Return is calculated by subtracting the Estimated Loss from the Effective Yield. Effective Yield is equal to the borrower interest rate: (i) minus the servicing fee rate, (ii) minus estimated uncollected interest on charge-offs, (iii) plus estimated collected late fees. Estimated Loss is the estimated principal loss on charge-offs. Effective yield, Estimated loss and Estimated return are intended to represent the estimated average effective yield, loss and return, respectively, on a basket of loans with the same characteristics. All estimates are based on the historical performance of Prosper loans for borrowers with similar characteristics. The calculations of Effective yield, Estimated loss and Estimated return require significant assumptions about the repayment of loans, and lenders should make their own judgments with respect to the accuracy of these assumptions. Actual performance may differ from estimated performance.