With market volatility picking up in both bonds and equities and uncertainty as to whether the 10-year bull-run since the global financial crisis can continue for much longer, investors may wish to diversify their portfolios.
One way that Shore Capital director Ben Yearsley is doing this this ISA season is by making use of the little-known innovative finance ISA.
The new Innovative Finance ISA – or IFISA for short - allows investors to use some, or all, of their annual ISA investment allowance to lend capital through the growing peer-to-peer (P2P) lending market.
The sector is a rapidly growing form of lending that serves three key sectors; personal loans, small business loans and property loans – all of which are available through the ISA.
It can offer investors improved returns as the lending process removes the need for banks – or ‘middle-men’, meaning that investors receive the full returns.
However, investors are not able to invest in equity-based vehicles, meaning that other high-risk, high-return options such as crowdfunding ventures are not applicable.
He said: “I did it back in April and I have just done next year’s one as well – one of my bonds is maturing in April and I have reinvested into a new one for the next tax year.”
Yearsley said that the reason he has looked at this new ISA – introduced in 2016 – is because he is unsure of where markets will go from here.
“Markets have obviously gone up a lot and bond markets don’t look that attractive so at a time when markets weren’t looking cheap last year, and they are still not looking cheap now, I thought peer-to-peer was an interesting way of using my ISA allowance in a small way,” he said.
Performance of indices over 10yrs
Source: FE Analytics
Indeed, over the last decade, UK investors would have made 153.38 per cent from global equities as measured by the MSCI World index and 84.58 per cent from global bonds (Bloomberg Barclays Global Aggregate index).
Yearsley made his first IFISA investment back in April 2017 in a bond that is linked back to an individual pub company.
“I had the opportunity last year – or technically this tax year – to get something like 7.25 per cent from that bond,” he said.
This sits right within the government’s suggested expectations for investors using the IFISA of yields between 6 and 8 per cent per year.
“It is on the freehold of the pub so I am asset-backed, which means I have security over the property as if anything goes wrong the bondholders get that property because they have first charge over it,” he noted.
He uses the Downing Innovative Finance ISA, which launched in March 2016 and so far has 0 per cent bad debt to date – when the borrower fails to pay any interest or capital due to investors.
The average yield of the bonds on the platform is 6.17 per cent per annum, though Yearsley’s bond is slightly higher than this.
“If it was only paying me 3 per cent would I have done it? Absolutely not, no I’m not interested. But when I assessed the risk at 7 per cent I thought it was an interesting opportunity and when inflation is 2 or 3 per cent it is a nice return,” the director said.
However, he noted that while he used the allowance this year, and plans to do so again next year, he may not the following year. It all hangs on where interest rates are.
“It depends on the rates. If interest rate yields have [risen] to 5 per cent then is it worth the risk? No it probably isn’t,” he said.
Federal Reserve dot plot interest rate expectations
Source: Federal Reserve
The Federal Reserve expectations are that by 2020 interest rates will be around 3.5 per cent, though one member believes rates could rise to nearly 5 per cent, as the above chart shows.
In this scenario, investors would more likely look to return to cash. Additionally, if the yields on the bonds available in the ISA fall to around 5 per cent it would be wiser to invest in equities, with the Schroder Oriental Income trust his preferred vehicle – as discussed last week. 
This is because not only are investors receiving the 4 per cent income yield but there is significantly more scope for higher capital gains.
The other thing investors need to be aware of before taking the plunge into the world of peer-to-peer lending is that the investment options are more limited.
When using a traditional stocks and shares ISA investors choose a platform before then deciding on the underlying investments from asset management firms.
“With the peer-to-peer stuff, you choose your platform and the deal flow is from that same manager,” Yearsley (pictured) said.
“You don’t get to mix and match so are less flexible. You have to do the due diligence on both the platform and the types of investment they have before making a decision on who to invest in for the tax year because you don’t get to pick and choose,” he added.
However, for those looking to add genuine diversification to their portfolios it remains an attractive, tax-free alternative to the stocks & shares ISA, he said.
“I like doing different things and having uncorrelated assets. I think it is an interesting area but the higher the return the more risk to capital,” Yearsley said.