The real risks and rewards of trade receivables

A decade on since the early days of the Global Financial Crisis, and the consequential monetary and regulatory policy decisions continue to shape markets. Indeed, some policies implemented as a response to the crisis have created a challenging investment environment, particularly when it comes to the US debt market.

A newly published white paper, Trade receivables: an investment alternative in a world with low but rising rates, explores how investors have been increasingly dependent upon investing in US Treasury securities and government and prime Money Market Funds with their short-term money, and are seeking diversification through alternative forms of investment.

Authors Adam Dener, Managing Principal at Fermat Capital Management, and Lance Doherty, Director of Treasury at Pacific Life Insurance Company, point to confirmed receivable purchases as one option – a form of trade finance that offers high quality, corporate credit risk in a floating rate, short-term product. They spoke with TXF about the risks and rewards of investing in trade receivables.

TXF: Why is this the right time to consider investing in trade receivables, and why hasn’t it taken off as an asset class before?

Adam Dener (AD): There are market structure issues as to why investors might not have considered trade receivables before the regulatory changes implemented after the Global Financial Crisis. These issues are tied to monetary policy, when central banks implemented quantitative easing and began making investments and buying securities that were typically acquired by a real money investor such as Pacific Life. That has significantly impacted the availability of more traditional investment products, and also had an impact on yields for those products. Investors now have to work harder to find a decent return on their investments - certainly more than they would have had to 10 years ago.

Lance Doherty (LD): Ultimately there has been upheaval at the short-end, medium, and the longer term as the market has readjusted. It is harder to find investment assets than it used to be, so that has pushed the investors to look at new asset classes.

TXF: What makes trade receivables an attractive asset class?

LD: The short-term nature is particularly appealing. The majority of the receivables that we buy are 90 days and have a named credit attached to them. If we were to begin to feel uncomfortable with them, we can stop investing and get out relatively quickly compared to longer-dated investments. To use an analogy, you can stop filling up the bucket, and let it drain out!

TXF: To what extent has money market reform played a role in the development of this asset class?

AD: 10 years ago, you didn't need to search for these types of yields, the prime money market funds had them already. However, these days, following reform, average maturities have become significantly shorter for products to stay compliant, and as that happened, competition for those assets became more acute, and you had a reduction in effective yield. The non-Treasury elements of the money markets have become considerably less desirable.

This has had an impact on the principal borrowers that fund themselves through those products - the banks. They are no longer able to get as much longer-dated financing from the sector and so have been transitioning to other ways of funding themselves, which inevitably means paying more for funding, and that’s had an impact on bank P&Ls.

LD: Banks that have traditionally funded themselves through prime money market funds have had to go elsewhere, increasing competition for those new target assets. Demand for shorter-term corporate credit, such as trade receivables has picked up considerably.

An important point is that prime money market funds have effectively become bank exposure, and government market funds have become government exposure. What trade receivables offers is true corporate exposure. It is a great diversifier as an asset class.

AD: Further to that, because the overall yield curve is flat, there is limited incentive for borrowers who can go further out in term to borrow short. So, non-bank corporates have no incentive to issue commercial paper, or short-term notes, when they can borrow out to ten years plus for not a significant difference to if they had issued commercial paper 10 years ago.

In addition to diversification, the issue for investors, such as Pacific Life, is that they can't find access to short-dated investment grade corporate credit risk, because very little gets issued given the monetary policy implications. Therefore, almost all the issuances that occur are bank exposure. We hope that what our white paper effectively demonstrates is that if you wanted to own short-dated corporate credit risk there are currently limited ways to access it.

TXF: What should potential investors be aware of before pursuing a trade receivables investment strategy?

LD: The main thing to consider is the operational and structural risk. It is not like buying a bond and holding onto it, you really do need a solid administrator managing operations in the background, as there are a lot of moving parts to trade receivables.

AD: If you think of a bond that has a credit rating and a public issue, proportionally if you thought of the two principal risks being operational risk and credit risk, then a bond's risk is more weighted towards the credit risk. With trade receivables, it's much more about operational risk. Complicating the matter is the fact that trade receivables are structured as non-standardized private placements, which makes it even more important for there to be educated investors and domain-specific investment management services. There is real value-add in being able to evaluate the operational risk. An investor can get more for this credit risk if they properly understand the operational risk.

LD: It makes sense for this to be in a fund structure as, for us as a medium-size insurance company, to go in and buy these assets individually is not an easy task - you have to build up the operational expertise which is not an easy thing to do. A fund structure makes sense as you have the experts that can benefit off the economies of scale.

TXF: Could this be expanded to include other forms of trade finance or receivables?

AD: We think this is a very compelling investment class. Not just for trade receivables - there are other forms of trade finance that could be fundamentally beneficial investments in a fund format. Certain types of trade finance securitizations are attractive. Other forms of receivables purchase are attractive, they just have different operational risk, and different regulatory implications. What makes confirmed receivable purchases more attractive is that they are the most bond-like.

Sophisticated investors like Pacific Life are more than capable of looking at the others, but there are regulatory hurdles. In general though, we believe that confirmed receivable purchases, other than rated securitizations, are the most easily moved in a private placement market to non-bank investors.

The full white paper: Trade receivables: an investment alternative in a world with low but rising rates is available for download.