Forget the U.S. government — how about lending to your neighborhood dentist instead?
That’s what firms like Direct Lending Investments aim to allow investors to do, albeit indirectly. The $450 million fund buys loans from nonbank lenders, and packages them in portfolio form for consumption by accredited investors (although it is attempting to transition into a more accessible closed-end fund).
The potential opportunity arises from a few different factors. Over the past several years, traditional bank lending has slowed, and yields on Treasurys and other ultrasafe bonds have fallen, which has increased the demand for nontraditional loans, resulting in outsized yields.
For instance, even as Treasury bonds returned basically nothing in 2015, Direct Lending Investments delivered an 11.7 return. This as the default rate on loans in the portfolio ran at 4.6 percent.
According to Brendan Ross, who founded and runs the fund, the extra yield comes not from increased credit risk, generally considered to be the primary source of enhanced yield in the fixed income world, but from other sources.
“The premium we tap into is related to the bank decline in lending to small businesses. And that bank decline comes from the fact that banks find it difficult to securitize the kind of short-duration loans that we have in our portfolio,” Ross said in a Friday interview on CNBC’s “Trading Nation,” referring to loans that tend to expire in about a years’ time.
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“When investors begin to peel the layers on this thing, what they’ll find is they don’t find nearly as much risk as you’d expect to find with these sorts of returns.”
In addition to being a decent deal for investors, the securitization of short-term small-business loans could have a positive effect on the small-business landscape, according to Rob Ashbaugh, senior risk management consultant at Sageworks, a financial information firm focusing on privately held businesses.
If this type of investing increases in popularity, “it would help the environment, and it would certainly create liquidity,” Ashbaugh said.
However, for potential investors, Ashbaugh warns that their small-business loan exposure may not provide the diversification they might expect.
“There’s a little bit more economic risk with these investments,” compared to traditional corporate bonds, Ashbaugh said. In a potential downturn, “those are the borrowers likely to default first.”