What do higher interest rates mean to buy now, pay later?

It’s been a volatile year across nearly every asset class, with investors focusing on ongoing inflation and what the Federal Reserve will do to combat it.

In times of inflation, the Fed seeks to raise interest rates to suppress demand and stifle rising prices. These interest rate changes are having a ripple effect across all markets, including the buy it now, pay later (BNPL) industry. Companies in the sector are facing headwinds from rising borrowing costs – here’s what you should consider before investing in the sector.

Once-thriving BNPL businesses have come down to earth

Buy now, pay later options have grown rapidly in recent years, driven by low borrowing costs and strong consumer demand for goods. The industry grew at a compound annual growth rate of 85% from 2019 to 2021, with Millennials and Gen Z customers shifting to low-interest installment plans.

Initially, a few big players dominated the industry, including To affirm (AFRM 9.45%), Afterpay and Klarna. Affirm went public in early 2021 and reached a market capitalization of nearly $48 billion during the year. The stock fell back into orbit, sporting a valuation just north of $5 billion, down nearly 90% from its peak. Klarna, Sweden’s BNPL bank, saw its private valuation rise from $46 billion last year to $30 billion in its most recent funding round.

AFRM Market Cap Data by YCharts

What Higher Interest Rates Mean for BNPL Businesses

The industry faces headwinds from inflation and rising interest rates. In May, the consumer price index rose 8.6% year-on-year, beating economists’ expectations.

BNPL lenders face two problems. First, consumers may find inflation too difficult to manage, and could reduce spending on goods and services, which means fewer lending opportunities for BNPL businesses. Second, rising interest rates could make it harder to fund these loans.

In order to fight inflation, the Federal Reserve has pledged to raise interest rates. This year, the Fed has raised the federal funds rate from near zero to 0.75%. Analysts expect the fed funds rate to reach 3% to 3.25% by mid-2023.

BNPL companies thrived when low interest rates ensured lower financing costs and plenty of money to lend to consumers. However, BNPL companies rely heavily on borrowing to continue funding their operations, and the cost of borrowing for these companies has increased significantly over the past year. For example, Klarna has seen its borrowing costs rise to an all-time high. As borrowing costs rise, it will be more difficult for BNPL’s lenders to grow as quickly as before.

What I look for before embarking on these actions

BNPL companies are entering uncharted territory and facing rising interest rates and a possible slowdown in consumer spending. Bank chartered companies, such as Block Inc., which owns Afterpay and Klarna, a private company, might fare better because they have deposits that could fund their loans. Interest rates on customer deposits are rising more slowly than the cost of debt, which could provide stability for lenders. Earlier this year, Klarna said Bloomberg that 80-85% of its loans are funded by customer deposits.

Companies without a bank charter, like Affirm, could struggle as their funding costs rise, squeezing the company’s margins.

The industry also faces other headwinds, including Applein space and increased regulatory oversight. For this reason, I avoid investments here in the near future. Still, I’ll keep an eye on interest rates and consumer delinquencies for those like Affirm and Block, Inc. over the coming quarters and reassess.

About Wanda Dufresne

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