Justin Pugsley explains how technological advances in the way international trade is financed could open up a new kind of short term investment for pension funds
Currently, trade finance is almost exclusively carried out by banks. But some of the more aggressive banks are beginning to seek a wider universe of investors to help with funding. This could create some interesting openings for pension funds.
Trade finance largely involves lending money, usually for up to 120 days, so corporates can sell their goods on credit or to enable them to fund their purchases from suppliers. In the context of international trade, these transactions have traditionally been done on letters of credit. However, that's changing. Most large manufacturers and retailers are now organised around supply chains of trusted counterparties.
Thanks largely to that development, letters of credit, which are expensive to use, now account for less than 20% of world trade transactions. Typically, they have been replaced by open account transactions, basically simple money transfers.
Technology is also playing a key role in the way international trade is transacted and financed. The internet enables the buyer, the seller and their banks to follow a transaction from beginning to end. Typically this takes place through an internet portal hosted by the buyer's bank. From there, purchase orders, invoices and other trade paperwork can be monitored, approved, disputed and resolved. This is giving banks unprecedented visibility of their clients' supply chains. Now new financial products are being created for this new medium.
One such development is to use the usually superior credit rating of the buyer to finance the capital requirements of suppliers. In simple terms, the buyer's bank(s) lend money to the suppliers on the buyer's promise to pay. Crucially, for the suppliers, that means cheaper financing, but the bank still charges a higher margin than it would if it was lending directly to the buyer. It is effectively doing an interest rate arbitrage. For a Chinese-based SME the savings can be dramatic. It can get paid upfront by the buyer's bank at a discount, whilst the buyer can extend its credit terms, which frees up working capital. This is called supply chain finance (SCF).
The opening for pension funds
For banks, SCF means they can grab a bigger share of their clients' business. However, John Ahearn, global head of trade services and financial institutions at Citigroup, explained: "Credit committees can get uncomfortable with high levels of exposure to one name. It's useful to be able to parcel out some of that debt to others."
The traditional way to get around that is to syndicate the debt to other banks. But banks are now trying to spread the net wider and this is opening up opportunities for non-traditional players. As SCF gathers momentum, the need for outside investors should become more pressing. In recent years, a plethora of specialist funds have started up to exploit this rapidly evolving niche. They're ideal partners for banks as they're regulated differently and have different selection criteria.
Some invest in bonds backed by trade receivables, basically securitisations, others simply buy the receivables and yet others write credit default swaps.
For a pension fund, investing directly in trade receivables isn't practical. An easier route would be either to invest in asset-backed bonds or a specialist fund.
As an asset class, trade receivables have much going for them. According to bankers, they're often safer than implied by the borrower's credit rating. They say defaults are fairly rare. For investors it can be an opportunity to achieve relatively safe yields, which are higher than similarly rated assets.
"The risk of default is minimal in the short term," explained Bob Kramer, vice president, Working Capital Solutions, with trade services platform provider, PrimeRevenue. "You're also talking about exposures to big household names in retailing and manufacturing. It's an ideal risk profile."
James Klatsky, senior managing director of Rosemont Capital Management, a specialist fund that invests in trade finance assets, claimed he had yet to experience a default. That reflects the relatively safe nature of these assets as well as the rigorous selection criteria. The transparency offered by SCF should make it easier to monitor the performance of borrowers, adding another level of comfort for investors. According to Ahearn, SCF should create paper highly marketable to insurance companies and pension funds.
"We focus mainly on emerging market trade receivables," explained Fritz Vom Scheidt, managing director of Tricon Trade Management. "We use various analytical tools to analyse transactions before we invest in them." He added investing in emerging market trade receivables was not as risky as it might first appear. Moreover, it can produce returns of 200 to 300 basis points over LIBOR. Given the short tenors of up to 120 days or one to two years for bilateral loans and structured transactions, this is a very attractive return. It can beat emerging market bond returns.
"We ran some default models on this and concluded that should something like an Asian style crisis occur, these countries are unlikely to default on the payment of imports for items such as food." Indeed, during the last Asian crisis, many of these countries did continue to perform on trade finance. With emerging market countries generally heavily reliant on international trade, they're likely to pull out all the stops to keep it going, even in times of crisis. This gives investors considerable comfort.
Another factor, said Vorn Scheidt, is that Tricon invests across a wide range of trade receivables to mitigate risk. Tricon currently has around US$200m under management in a hybrid Shariah compliant fund, which has been bought into by investors from Saudi Arabia and the United Arab Emirates. However, it is currently raising $200m to $300m for another fund dedicated to investing in trade receivables.
Vorn Scheidt added that the transparency offered by supply chain finance should in theory help with evaluating loans. However, he said he was yet to see any such paper in the market.
Rosemont Capital's fund is also geared towards emerging market trade receivables. The focus of this fund is to look more at liquidity rather than just high yields.
Both funds buy trade receivables directly and do not invest in bonds backed by trade receivables. They're also not leveraged.
However, remaining 90% to 100% invested at all times can be hard work for the manager. Vom Scheidt reckons there's a 50% turnover in the fund's portfolio every year. That's far higher than would be seen with, for example, an emerging market bond fund. As trade receivables mature and become cash again, replacement investments have to be found. But with relatively few funds in the market, finding assets shouldn't be too difficult. Also, the credit crunch may have created a bit more of a buyer's market. Many banks are preferring to hoard cash at the moment.
There are other funds which also specialise in investing in trade finance assets. They include IIG Capital and Eden Rock Capital Management. Each have their own particular investment style, approach and benchmarks. Some also have the backing of pension funds.
Accessing trade receivables
Another way to invest in trade receivables is via hedge funds, which write credit default swaps (CDSs). For a bank that wants to keep receivables on its book, buying CDSs is one way to do so and still meet its regulatory obligations.
"Simply taking out a CDS can work out cheaper and easier than securitising the loan and selling it off," explained a specialist hedge fund manager who asked to remain anonymous. "By using CDSs, a bank can increase the credit rating of its trade portfolio and benefit from the capital adequacy framework set out in the Basel 2 regulations."
In effect, the hedge fund can offer to guarantee losses equivalent to say 10% of the pool of the assets. This acts as a buffer to the remaining 90%, which can be sliced into tranches with different credit grades. The hedge fund is effectively acting as an insurance provider.
He added that there was the equivalent of about $10bn in trade finance risk asset value currently available from hedge funds. "It's a quick and efficient way for banks to transfer risk and CDSs are a flexible solution," he explained. CDSs may well grow in popularity as the recent credit crunch has made investors temporarily weary of securitisations.
However, "the concept of securitisation is still sound and remains proven," explained Averina Miller, senior vice president with supply chain finance specialist, Demica. "We have seen a drop off in the number of securitisations, liquidity has dried up for the time being."
Even so, some hedge funds are reported to have stayed away. This is possibly because of some of the high profile problems with hedge funds investing in securitised bonds backed by sub-prime mortgages. It is, however, an unfair comparison. Trade finance is a very different type of asset to residential mortgages.
Once the credit crisis passes and margins come back down, the securitisation of all kinds of assets is likely to pick up again. For investors with a disposition towards cash type assets, trade receivables should make an attractive alternative.
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