The increasingly persuasive case for investing in trade finance was discussed in a Professional Pensions webinar held on 7 September 2022.
During the webinar, Allianz Global Investors head of global high yield David Newman gave an in-depth insight into new opportunities arising within the asset class for pension portfolios.
He said companies and their banks have long financed payments under commercial contracts with risk sitting on either corporate balance sheets or the bank.
But constraints on bank capital and recent changes in the direction of economic activity have created a funding gap that allows external investors to access trade finance and help bridge the shortfall - and Newman said the opportunity for pension schemes is significant.
The investment case for schemes
Newman began by explaining how trade finance works and what it might offer to defined benefit (DB) schemes.
He said: "We have seen clients looking at trade finance as an alternative to traditional credit assets, such as asset-backed securities or short-dated investment grade.
"The reason is, there is an increased yield due to the complexity premium - but not an increased risk."
Newman said that because trade finance is relatively stable and not sensitive to rate changes it can also be used as a replacement for government bond holdings - something of keen interest to investors.
He said it also allows DB schemes to get exposure to private markets, while retaining some liquidity, and can also be used as a funding source for capital calls.
Additionally, he said AllianzGI has noticed a trend in its clients replacing corporate credit with trade finance as it has shown "healthy and stable" returns while reducing volatility1.
Newman took the opportunity to dig down into the nature of trade finance as an asset class.
He explained that, in essence, it is simply credit, and outlined its role in receivables financing.
Newman said: "Also known as supply chain financing, this is when a buyer promises to go and pay a seller via an invoice.
"If you take an example where that buyer has very strong credit and the seller very weak credit, what we can do is let the seller sell the invoice to us today, then wait for the buyer to sell us.
"The seller is getting financing based on the buyer's credit risk - so the seller benefits."
Newman said there are other complicated iterations involving multiple or unknown buyers, but clarified that the increased risk is mitigated by credit teams or guarantees from the bank.
However, while he said trade finance could offer attractive double-digit returns in emerging markets, this area has also seen "high cases of fraud" and "major losses" in recent years, so caution was advised.
Back in developed markets, returns are often higher in the mid-market or from SMEs, and Newman said Allianz's provision in this area is a solid option due to it being "defensive" and "diversified" with "no conflicts of interest". Lower returns are available in investment grade trade finance or insured trade finance.
In terms of a practical application for sustainability goals, Newman said this asset class was capable, for example, of helping to finance a cocoa farmer in Ghana to help feed his village, when the previous alternative for raising funding is likely to be prohibitively expensive.
Newman concluded by making it clear that trade finance is an asset class that comes with risks in several areas including credit defaults, fraud and insurance. But added that Allianz aims to mitigate those risks with a conservative and prudent approach.
He added: "We have a number of sourcing partners, but we do our own transaction analysis and we have the right to say no with every single credit risk which we look at. We do not have a take or pay - we can say no to everything."
After Newman's presentation, Professional Pensions editor Jonathan Stapleton got the chance to ask some follow up questions:
Jonathan Stapleton: Are there any specific asset types you currently prefer over others, and any geographies that are looking more positive than others at the moment?
David Newman: The themes we see in global credit, we try to reflect in trade finance. If we were running a strategy with no diversification limits, what you'd see is that retail and oil and gas are the biggest parts of the market that you can source, with a little bit of telecommunications for 5G rollouts as well.
We prefer the US to the UK/European consumer right now, but we're not massively in love with the consumer space as a sector. Energy has some ESG issues but there are parts of energy - especially things on the renewable side, or energy companies that are Science Based Targets initiative (SBTi) signatories or who are actually lowering their carbon footprints - that are acceptable within our policies to look at.
Jonathan Stapleton: What's the typical size of the investments you're making, and when you work with sourcing partners, what's the typical block of assets you're buying?
David Newman: The largest position our guidelines allow is 5%. In round numbers, £500m of assets gives you an idea, so £25m blocks. That means that 5% would be investment grade or very strong double Bs. When we start to go into the single-B areas, those sizes fall quite heavily. Also, if we enter less developed markets, we take much smaller positions as well.
Jonathan Stapleton: Can you talk a little bit more about how your source your trade finance assets and your sourcing partnerships?
David Newman: We have our team of portfolio managers who talk to banks on a daily basis. They explain how we are going to be growing and that we need to have "x amount" more exposure. They'll explain where we might be overexposed - retail, for example -so we don't want any more of that, but the bank might have something in automotive or semi-conductors, so we would like to have a look at that. Within these relationships, we can say yes or no to every opportunity.
We find fintechs to be much more operational than banks. Often, they can look like an eBay of trade finance. This helps you when looking at pricing but, again, the due diligence and making sure the invoices are accepted are very, very important.
Within the alternative finance space, we have very strong partnerships. We have calls with the senior management teams on a very regular basis.
Jonathan Stapleton: There are probably still a lot of people remembering Greensill when they think about trade finance and this broader topic area. In your view, what were the major errors made there?
David Newman: First of all, there were fraudulent transactions; secondly you were reliant on them; thirdly you couldn't monitor it on a daily basis yourself. Last thing is that insurance doesn't cover fraud.
Jonathan Stapleton: What's the liquidity of the instruments in which you invest and who are you competing with at the point of purchase?
David Newman: There is no secondary liquidity in a trade finance receivable - or rather, this applies to 95% of the portfolio. So, if I buy a receivable facility, I can't sell it again. But what happens is - with an average maturity of 70 days - in 70 days it has disappeared and I can choose not to renew it. That gives me a natural liquidity within the portfolio that every 70 days. Either I renew the facility or I let it roll off and it creates liquidity. That's where the liquidity comes from.
Who am I competing with? There are other funds out there and we compete with them - they may bid for assets and we may bid for assets. What I would say is, according to the Asia Development Bank, there's a $1.7trn (£1.54trn) shortfall in financiers for trade finance versus the availability. Therefore, there shouldn't be a capacity constraint or a bidding war of one fund against another fund.
Jonathan Stapleton: Is there a continued expectation that banks and other sourcing partners will continue to sell off the trade finance assets?
David Newman: In my view, absolutely. Inflation… I don't want to say it's good but if a bank facility is for £100m and there's inflation of 15% next year, that £100m of financing is now £115m of financing, and they may not have the facility for it. And unless they can increase their balance sheets - which typically in a slow down they don't do - they need to go and find someone who can finance that. We, and our, competitors are there to step in to do it.
Jonathan Stapleton: What sort of return is your fund targeting?
David Newman: We are targeting net of all fees about LIBOR plus 200 or the SONIA plus 200. That's net of a management fee of 40 basis points. Clearly for large pension funds everything is always negotiable but that's net of the 40-basis points fee schedule.
Jonathan Stapleton: What are your key conclusions and takeaways after our discussion?
David Newman: We came up with the idea of trade finance in 2015 and spent a couple of years developing it and making it look and smell like a credit portfolio rather than some niche product reliant on a single person or market. I think over the last three years or so, the proof has been in the pudding - it has met its return targets1; it has seen the low volatility; and we haven't seen any defaults on our core book.
Of course, the past is not a guide to the future, but I think we have put together something which should be considered as an alternative to other short-dated credits.
This webinar was held on 7 September in association with Allianz Global Investors. To view the webinar in full, click here.
For more information on investing in trade finance, click here.
1Source: Allianz Global Investors, July 2022.