With the decade rapidly coming to an end, risk indicators suggesting an impending economic downturn, and the market’s attention focused on heightened geopolitical risk, it is no wonder investors are seeking uncorrelated strategies in their hunt for return. For some, this means reshaping portfolios with alternative strategies that offer better protection for investors’ capital.
Looking ahead to 2020, where should investors turn to find strong, risk-adjusted returns from liquid investments when opportunities in traditional markets have been exhausted? We believe the answer can be found in one of the oldest, and least fashionable, corners of the global economy: Trade Finance.
The search for return has led many institutional investors to alternative investments in private markets – and at staggering rates. This year alone, US$778 billion of new capital has flowed into the space due to a growing belief that private markets are essential for diversified participation in global growth (cite).
Direct lending, in particular, has surged as funds continue to fill the space left by traditional banks, which have been forced to scale back as a result of post-crisis regulations. This shift has led to some of the largest capital flows into corporate credit right at a time when corporate credit risks may well be increasing. Meanwhile, competition over loan origination is pushing down yields at the very moment investors should be demanding greater returns to reflect the risks being taken.
We believe there are certain areas of private credit that will continue to offer secure, uncorrelated investment opportunities should a recession hit in the new year. Specifically, we see compelling openings in Commodity Trade Finance, which has – until now – remained relatively untapped by investors.
Trade Finance is a longstanding pillar of the global economy. While its roots can be traced back thousands of years, the industry experienced its greatest developments during the Renaissance, when the Medici family pioneered the letter of credit as a financial instrument (cite). Remarkably, this innovation continues to form the key part of collateral for trading opportunities today. And now, more than ever before, institutional investors outside of the realm of banking can access it.
Large financial institutions and trading houses have historically supplied the majority of credit needed to finance the flow of trade. The implementation of Basel III in January 2019 and the pending requirements of Basel IV have changed this, creating significant challenges for the European banking landscape. As methodologies for determining banks’ capital requirements are being pressurised and revised, innovative managers have stepped in to fill the funding gap, recognising the attractive characteristics of Trade Finance and the opportunities it offers investors.
A general lack of understanding of Trade Finance often means it is viewed as a ‘niche’ asset class. In reality, the opportunity set is broad; in fact, the term ‘trade finance’ covers a huge range of activity valued at over US$16 trillion annually (cite). Trade Finance investment strategies facilitate economic growth in developing economies by providing financing to many family-owned SMEs and supplying global consumers with foodstuffs and energy. Despite its global impact, most investors remain unaware of the depth of the opportunity.
Growth of this investment class has been largely hampered by false assumptions about the investment risks in Commodity Finance. Investors’ hesitance stems namely from the belief that they are taking big risks through exposure to price movements in the cargo of commodities, to emerging markets and currencies, or to the credit worthiness of the SME. In actuality the risk is low. The risk profile measured by defaults is better than BBB-rated corporate bonds, with overall default rates of between 0.04% and 0.21% (cite). More importantly, the recovery rates are far superior. To illustrate the diversification benefits for investors, these statistics remained virtually unchanged during the financial crisis, where the financial markets collapsed at the same time as the world commodity prices collapsed.
Additionally, investors often fear that investing in alternative credit means capital is tied up for years, but Trade Finance offers liquidity (on average 15-50 days duration) and can be accessed via open-ended structures. By their very nature, trade finance transactions are self-liquidating, asset backed and transparent, allowing an investor to understand the returns and tenure before allocating capital to the transaction. This will be valuable if a downturn does come.
The threat of a global recession may continue to loom, increasing anxieties for advisors and their investors. For those looking towards alternative private credit strategies, we maintain that trade finance should not be overlooked.
Published by European Financial Review on 23 December 2019.