Trade finance can offer an illiquid position in a volatile market, but its idiosyncratic nature can dissuade investors

International trade in manufactured goods and commodities underpins the global economy – with $16trn in 2016, forecast to grow to $19trn by 2020 according to the International Chamber of Commerce (ICC). Cambridge Associates estimates 10% of these flows are enabled by traditional trade finance. However, the regulatory pressures on banks following the global financial crisis is making trade finance a more expensive proposition in terms of capital, leading to opportunities for institutional investors.

The scale of the market suggests that trade finance can offer attractive risk-adjusted returns for many years. The problem however, as Suresh Hegde, head of investment solutions at NN Investment Partners, argues, is confusion over what the term represents. The opportunity set covers structures ranging from low-risk government guaranteed credit, to leveraged structured finance with equity-like returns, as all these are given the same description as trade finance.

That confusion has caused a bottleneck in generating institutional interest. Fund managers offering trade finance structures need to focus on defining which segment they are focused on and how it relates to an institutional asset allocation framework.

Banks have had to respond to the regulatory environment in two ways, says Himanshu Chaturvedi, a managing director at Cambridge Associates. First, they have sold participations in deals to reduce their overall exposure and secondly, they have focused on the largest clients to the detriment of small and medium-sized enterprises, particularly those in the emerging markets.

This, argues Chris Newman, managing partner of Audentia, has resulted in a funding gap exceeding $1trn of lost economic value, but it also hindered the development of emerging economies, which ultimately stalls the global economy. Moreover, he adds, this situation could worsen as full compliance with the Basel III bank capital adequacy requirements further reduced the amount banks are able to lend. The next round of regulatory reform will be implemented over the next few years.

The essence of trade finance is that it transfers the credit risks for buyers and sellers of goods and commodities away from distant counterparties to their local bank. The banks in turn, only need to assess the credit risk of the counterparty, rather than any enterprise in an unfamiliar territory. “Oil, wheat and all the other essential commodities will not move without trade finance,” says Newman.

The opportunity for investors to participate is vast and there are different approaches with different risk/reward profiles to consider. The lowest yielding is a participation in a trade finance loan, which passively holds the exposure to maturity. Risk is controlled through diversifying portfolios with varying tenors and the recovery efforts of arrangers. Partnering with financial institutions offers the ability to generate deal flow from the banks’ own activities and the requirement to manage risks by syndicating exposures to partners.

The challenge, says Hegde, is building diversified portfolios, as any bank would typically be offering large sizes from a small number of clients. New fintech platforms are being constructed that will enable such trades. There are also opportunities to invest in loans guaranteed by government export credit agencies which, says Hegde, enable investors to take on sovereign risk, albeit illiquid, yet generate 80-100bps spread over government debt for five to seven-year duration amortising loans.

A higher return approach is to replicate the origination and arrangement activities of larger banks, but with smaller borrowers. This requires funds to evaluate borrowers and commodities as well as have the infrastructure to collect and review documents, track shipments, monitor collateral, and secure payment. Cambridge Associates finds funds pursuing this model typically aim to earn mid to high single-digit returns, with some aiming at double-digit returns by pursuing riskier borrowers or longer-tenor, pre-export projects. Investment funds can generate higher returns by taking on the risks of loss up to certain limits. For example, a fund could rely on banks as the originating channel while taking on some risk. For instance, it may agree to fully bear losses after the first 1% and up to the first 7%, at which point the bank would begin assuming losses.

Higher returns are potentially available through structured transactions involving investment funds issuing guarantees to banks on a leveraged basis. Such participations are complex and idiosyncratic but can be made to work with the right experts involved, says Newman. The challenge for investors is understanding how they should work and in which class of assets such transactions should be placed – hedge funds rather than fixed income may be a better descriptor for such strategies.

Default protection
The level of default rates is critical. High quality data is lacking but statistics from the ICC shows significantly lower rates than for other credit opportunities. Cambridge Associates warns that these statistics are only indicative and as they are self-reported, may suffer from omissions that flatter the results. They also vary by geography, with African trade finance default rates close to 5% versus the overall 0.04-0.21%. But as Cambridge Associates adds, the 5% default rate, while relatively high, is lower than the 9% default rate for all African bank assets.

Hegde makes the point that trade finance is a good example of a market that displays a combination of limited fundamental credit risk with desirable and controllable complexity for which investors are well compensated. Trade finance markets also are ones in which risk of standardisation is less likely to occur as transactions tend to be idiosyncratic. Hegde says: “These features offer a compelling opportunity for investors being forced out of other asset classes due to over-demand and falling complexity compensation.” As he points out, given that these areas are either longer-dated and AAA-rated (for example, government-guaranteed export finance) or in the case of trade finance are BBB/BB-rated with short maturities, they offer conservative illiquid positioning in a turning market.

Guaranteed export loans can be used as a defensive, better-yielding substitute either for government bonds or investment-grade credits, and short-dated trade finance loans as a capital-efficient credit or even a yield-enhanced cash substitute. Crucially, Hegde points out, the fundamental credit risks in these markets are similar to those found in standard corporate and government bonds. That is the additional spread compensation versus liquid bonds of the same risk really relates to complexity risk only and not hidden or esoteric credit risks.

Will trade finance become a mainstream investment for pension funds? It has the potential, but like emerging market debt, the name can be misleading as a descriptor for the risk return trade-offs that investors can face. In both cases, the spectrum of opportunities and risks is too wide for a single descriptor to adequately hint at what role the asset could play in a portfolio.

May 2019 IPE Magazine
By Joseph Mariathasan