Credit investors breaking some investment rules! Some of the time.

More return with less risk? Absolutely. We are exploring one segment in the Asset-Based Lending (ABL) space, and we are discussing the underlying dynamics, particularly in the context of risk/return.

In theory, all else being equal, investors should always expect higher returns in exchange for taking on higher risks, and vice versa. This principle underpins the concept of risk-adjusted returns in liquid markets with rational market participants.

But there are lending markets which show slightly different dynamics than what you ‒and the financial literature ‒ would expect. These include certain segments of the Asset-Based Lending (ABL) markets, in particular in the consumer credit card debt market. We are currently observing in this segment (historically) rising returns 1 while risks remain — in our view — low. In general, the asset class is a credit investment with contractually agreed returns and therefore a high degree of capital preservation. 2 However, ABL markets are currently only accessible by institutional investors, while the benefits this asset class offers may also be relevant for Family Offices and high net-worth individuals (HNWI) who would qualify as professional investors.

In the following article we will analyse this market segment in more detail and provide our findings. As always, this article covers only our own personal views and investment experience in ABL markets. 3

Credit card interest rate margins at all-time high

U.S. consumers are increasingly voicing concerns about high interest rates, and with good reason—they have risen significantly. Many of our friends and their families have felt the impact, as most U.S. households rely heavily on credit to cover their expenses.

• The average annual percentage rate (APR) for new credit card offers has almost doubled in 10 years to 22.8% (2023). The APR was 12.9% as of May 2013. 4
• The increase in the APR was driven mainly by two factors:

• Prime rates represent a good proxy for banks’ funding costs, which have increased in recent years. These are influenced indirectly by Fed rates.
• APR margins: the margin a credit card issuer charges to run the business, provide for potential losses and make a profit. Credit card issuers have also sharply increased margins resulting in average APRs rising beyond changes in the prime rates.

Nearly half of the increase in average APR over the last 10 years has been driven by issuers raising their APR margin.

Credit card debt is a large and growing market

U.S. household debt ticks up to $17.80 trillion in second quarter 2024 5

• Total household debt rose by $109 billion to reach $17.80 trillion, according to the latest Quarterly Report on Household Debt and Credit of the Federal Reserve Bank of New York:
  • Mortgage balances were up by $77 billion to reach $12.52 trillion;
  • Auto loans increased by $10 billion to reach $1.63 trillion;
  • Student loans increased to $1.59 trillion; and
  • Credit card balances increased by $27 billion to reach $1.14 trillion. The highest number ever on record.
• At the same time aggregate delinquency rates remained unchanged from the previous quarter, with 3.2% of outstanding debt in some stage of delinquency.

As margins have increased, the lending risk to consumers has decreased.

Charge-off rates are benign as APR margins keep increasing 6

In other words, lenders have gradually been earning more interest for taking less risk, as can be seen by the fact that the profitability of card balances, excluding loan loss provisions, has risen over this period.

Oligopol with low market competition

Why are margins so high? One key reason is that the U.S. credit card market is highly concentrated, with only around 10 to 15 major providers.

• In 2023, the top 30 credit card companies accounted for approximately 95% of all credit card debt, with the top 10 dominating the market.
• This market structure has often been criticized, as it allows large organizations to maintain high margins. While this may not be ideal for consumers, it creates a very stable and sizeable investment pool, offering significant opportunities for diversification.7
• These factors make credit card debt an attractive asset class for credit investors. 8

Average Credit Card APR by Issuer

The APR Range You Can Expect to Receive Based on Your Card Issuer

So how can private investors participate in these lending opportunities?

We have identified a resilient credit investment opportunity where risks have been declining while returns have been growing. 9The fact that this entire market operates only on a very large scale, primarily through institutional investing, explains why typical investors are often unaware of this (current) opportunity

• Credit card loans, along with other types of consumer lending arrangements, fall under the institutional asset class known as Asset-Based Lending (ABL). These investments typically offer returns of around 10% to14% 10, making them an attractive risk-adjusted investment opportunity. 11
• ABL can and should be part of a diversified investment portfolio for Family Offices and HNWIs. We as a family office for example have recently participated (directly or indirectly) in a USD 250 million facility to a US credit card company. We currently hold said investment (with over 1 million single borrowers) in our portfolio at an attractive return and with no losses.
• With 10 to 15 relevant lenders the market is considered to be concentrated, and facility sizes typically range from US$ 250 to 500 million per facility. Such facilities are typically provided as bilateral contractual agreements between an institutional credit manager and a credit card issuer company.
• Depending on how the facility is structured, credit investors have the option to invest in different risk classes and different returns. The card issuer and underwriter receives a fee for marketing, managing the credit card facility and relationship with the consumer.
• Therefore, typical returns of ABL investments can range from 10% to 14% 12, which on a risk adjusted basis is attractive in the current market conditions. From a risk perspective the following protective features should be considered:

What are the protective features of ABL investments?

• Highly diversified, granular asset pools: typically, one investor will finance portfolios of up to 1 to 2 million single credit card arrangements. This reduces risk as the lending amounts and potential delinquencies are spread across many individual credit card holders. Depending on borrower quality the charge-off rates are between 4% (long-term average) and 11% (peak 2011). For prime credit card borrowers the long term average is substantially lower, at around 1% to 1.5%. 13 It is important to note that charge-off losses are typically absorbed by the credit card company. In this case ABL investors are shielded from any defaults.
• Front loaded cashflow, high cash velocity: typically, credit card debt is repaid quickly, before people pay back auto loans, mortgages and other debt. This is mainly due to the high interest rates charged and the nature of the credit card.
• Additional safety measures by top credit managers.
  • A good safety margin for ABL investments that we at Tropeainvest look out for in our credit managers, is the assurance of investing in no less than 200% of Case 1 and 150% of Case 2 (Case 1: Base case: typical asset pool losses taken, Case 2: Recession cases: Indicates the level of historic losses based on peak defaults during the last recession, which serves as a proxy for future recessionary environments).
  • Conservative estimates of future losses. For good credit managers, that should be typically the losses on the counterparties worst vintage, assessed through statistical historic data. These assessments are only possible to top credit managers, who hold large proprietary statistical data pools.
• Resilience of returns against changes in the Fed rates:
• Current APR margins (the difference between Fed rates and APR) are at an all-time high, so mathematically any reduction in Fed rates has a considerably smaller impact on total returns.
• Over the last 10 years, average APR on credit cards have almost doubled from 12.9% in late 2013 to 22.8% in 2023 14 — the highest level recorded since the Federal Reserve began collecting this data.
• Fed rates reductions will not have a big impact. A reduction of 50 bps on a total APR 25% does not make a difference for a credit card borrower. So, while credit card rates may come down when Fed rates cuts happen, the difference for cardholders is minimal.

Our conclusion: If people are complaining about high interest rates on credit card debt, it is important to consider the situation from an investor’s perspective. Investing in credit card debt through the Asset-Based Lending (ABL) asset class can yield very attractive returns and provide significant protection for invested capital.15

As always if you have questions or would like to share your experiences please comment below.