In Investing Buzzword Bingo, the word “diversification” always makes the board. However, at Pier, diversification isn’t just a buzzword – it’s fundamental to our investing approach. In our investment team meetings, we constantly find ourselves asking if a decision enhances diversification or conversely increases concentration risk. We scrutinize diversification both at the level of individual deals and across the portfolio as a whole.
How can we achieve greater diversification within a given deal? Maybe it’s imposing limits on the maximum loan size, setting constraints on geographic concentration, or adjusting the mix of borrower sourcing channels, among others.
At the portfolio level, more obvious methods of diversification include increasing deal count, diversifying across borrower industries, and varying collateral types. Here are three examples of less apparent ways we try to diversify:
- Bank Selection for Borrower DACA Accounts: With 2023 bank failures fresh in our mind – and a looming regional banking crisis on the horizon, we prefer our borrower SPV cash accounts to be at multiple banks instead of concentrated at one.
- Loan Servicer Diversity: We steer clear of relying heavily on a single external loan servicer to manage our portfolios. If there’s stress in a particular borrower segment, the amount of work a loan servicer has to do to collect on loans can increase dramatically. What if that servicer can’t staff up quickly enough to handle the new needs of the current market environment?
- Credit Quality: Additionally, we look to invest up and down the credit spectrum. It may come as a surprise to some that prime credit doesn't always offer superior outcomes for a portfolio compared to subprime credit. It depends on the price and the relative multiplier of baseline default levels. Owning purely prime consumer credit in the GFC was pretty rough. Subprime consumer credit performed better from a relative multiplier perspective.
-Jillian
There has been recent chatter about the US government debt to GDP ratio. Now over 124%, it's been highlighted that, since 1800, 51/52 countries with more than 130% debt/GDP have defaulted.
This week, dv01 made a strong counterargument that if you compare total national debt (consumer + municipal + corporate + government) most economies today have significant debt loads, similar to US total levels.*
I have no firm opinion either way, other than to suggest what to watch. While these levels are important, I find it silly to only compare a balance sheet item (debt outstanding) to an income sheet item (GDP). Debt-to-GDP has never been the trigger to a default. It's the countries inability to service that excessive debt that does (income vs. interest expense).
So, watch debt-to-GDP ratios, but keep an eye on debt service coverage ratios as well. As highlighted in the below chart, personal interest ratios are on the rise. Mortgage rates and treasuries are both higher as well. It takes time for higher rates to flow through the economy. Just remember, as Ernest Hemingway wrote in The Sun Also Rises:
“How did you go bankrupt?” Bill asked.
“Two ways,” Mike said. “Gradually and then suddenly.”
- Conor
* dv01: "Performance Report: Consumer Unsecured & Subprime Auto" February 2024 Data Period
