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Enhancing Fixed-Income Portfolios With Trade Finance

A Growing and Dedicated Sector Within Fixed-Income

Uncorrelated Returns · Income Generating · Asset-Backed · Short Duration · Credit Insurance



EXECUTIVE SUMMARY

Investors Searching for Yield

Given that public markets exhibit elevated valuations and are priced for perfection, investors are searching for yielding assets that can provide a suitable investment to replace traditional fixed-income. In public market fixed-income, investors face the unappealing combination of highly levered corporate balance sheets, economic uncertainty, and compressed bond yields.

Seeking Quality Fixed Income Alternative

In the current market environment, investors need to take significant duration and credit risk to generate meaningful income. This has led investors to increasingly evaluate trade finance: a highly attractive fixed income sector relative to traditional bonds and other private credit strategies given the short-tenor and duration of the financings, collateralization of transactions, and the use of credit insurance.

The Right Segment of Trade Finance

Trade finance when combined with credit insurance as a hedging tool captures a highly attractive arbitrage opportunity within fixed-income. By funding companies in the middle and lower middle-market that generate an attractive yield and where the ultimate credit risk is transferred to an insurance company that is rated A or higher, investors are earning a significant excess return relative to what they can earn for a corporate bond with the equivalent rating.


Banks have historically not syndicated these assets as they provide a low-risk return for their balance sheet. Given financial regulation, many banks have significantly curtailed or exited the area due to capital charge requirements. As a result, this is a relatively new and expanding asset class for non-bank financial institutions and investors.

WHAT IS TRADE FINANCE? A DEDICATED FIXED INCOME SECTOR

Trade finance provides working capital financing for commodities, manufacturing, processing, distribution, industrial, business services, media, and/or other commerce-related activities in domestic and international markets.

The scope of trade finance includes factoring, supply chain finance, purchase order finance, and asset/receivable-based lending (collateralizing loans with assets/receivables), and pre-export finance. All trade finance transactions occur at the invoice and purchase order level so there is the financing of trade in the truest sense of the term.



TRADITIONAL FIXED INCOME FACES INCREASED CHALLENGES AND HEADWINDS

The current market environment is characterized by:

  • Elevated valuation across all asset classes with increased volatility – posing an adverse risk to long-duration assets

  • Rising leverage and reduction in credit quality: decline in AAA-rated corporations from 54 in 2006 to only 2 in 2019

  • Compression of yield across all sectors of fixed income

  • Central banks providing continued support through asset purchase programs resulting in a high degree of market distortion and mischaracterization of the true risk

Solution: Focus on short duration, collateralized, and credit enhanced investments given elevated risks and heightened complacency.




WHY TRADE FINANCE vs TRADITIONAL FIXED INCOME OFFERINGS?

Trade finance can provide an attractive risk-return profile relative to other short-dated fixed income instruments and products.

High Yield:

  • APR for factoring and supplier purchase financing is usually between 7-20%.

Strong Security Position:

  • Collateralizing investments with liens on assets, personal guarantees from shareholders, validity guarantees, and redirection of revenues to funder controlled account

Short Tenor and Duration:

  • Investment tenor of 30-180 days with frequent cash flow during the tenor of facilities.

Low Correlation:

  • Self-liquidating and short duration profile of financing results in low correlation to equity and fixed-income markets.

Low Default Rates:

  • Short tenor and duration results in low default rates during periods of economic contraction.

In contrast to trade finance, other private debt strategies take significantly greater duration risk (1-3 years), provide funds to companies directly versus funding underlying transactions at the invoice level thereby having less control and do not use credit insurance.



HOW DOES TRADE FINANCE GENERATE BEST-IN-CLASS RISK-ADJUSTED RETURNS?

Trade finance aims to capture significantly higher yields with lower duration while assuming investment-grade credit risk via the utilization of credit insurance. There is a meaningful arbitrage to capture when trade finance deals are credit insured, particularly for high yield companies that are not rated. By transferring risk to A-rated or higher credit insurance, the ultimate credit risk is transferred to the insurer.

  • Credit insurance policy insures 90-95% of principal and accrued fees -- High degree of principal protection

  • Risk transfer results in ultimate credit risk being taken on an investment-grade insurance company with a historically low level of default risk.



The above chart shows the cumulative default rates for companies based on their credit rating from 1981-2019. A-rated (or higher) corporations have an extremely low historical default rate, and that rate is close to zero for any given year. In fact, in most years, there are no North American corporations rated A or higher that fall into default. 2009 was the last year that an A-rated corporation entered default.


SUMMARY

In summary, trade finance is a dedicated sector within fixed income that has historically been the purview of large banks. It is a highly attractive investment complement to traditional short-term fixed-income instruments and fund vehicles and can generate a risk-return profile that can be significantly more attractive than high yield, with lower duration and credit risk.


Special Thanks to Our Contributor

Dipak Jogia

Managing Partner, Highmore

Dipak.Jogia@Highmore.com

T: 212 897 2810

www.highmore.com


Highmore is a global alternative asset management firm, investing in both public and private markets, directly and indirectly, across asset classes and investment structures.


Uniquely, Highmore's investment approach identifies the DNA of exceptional investment talent, because we believe the most reliable indicator of investment success is human behavior. ​Through a proprietary investment process that identifies those variables that most link to investment performance, Highmore brings the next generation of alternative investing to clients seeking genuinely differentiated investments.







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