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Achieving yields in the high single digits to low-teens without taking significant risk has become more challenging in structured credit after strong rallies in recent years in underlying traditional assets. However, one segment of this market still offers these yields on a compelling risk-adjusted basis. By Christoph Gugelmann, CEO at Tradeteq
This involves the securitisation of trade receivables. It is not as well established as other parts of the securitisation market, such as mortgages and credit card loans - hence the opportunity.
Diversification opportunity
Advances in tech, such as AI and automation, are creating an opportunity for institutional investors to access trade receivables. Besides offering compelling risk-adjusted returns, trade receivables are uncorrelated to most financial assets and therefore offer a diversification play. Their short tenors combined with advanced analytics also make them relatively low risk.
The underlying market for trade receivables is well established and worth over $3.5tn annually. Meanwhile, the global market for trade finance is worth $25tn with 80-90% needing financing, yet institutional investors provide barely 1% of the capital for this activity. There is a big role for securitisation in this commercial asset class as well.
Financing trade receivables is fundamental to the smooth running of the real economy and the ecosystem of micro, small to medium size enterprises (MSMEs) that are crucial to global supply chains. As an asset class, securitised trade receivables share some characteristics with corporate bonds in that they are an exposure to company credit.
How it works
Trade receivables are generated when a supplier to say Walmart wants its funds immediately rather than waiting 90 days to get paid as part of the terms of the contract.
Typically, smaller firms will sell their invoices to a trade receivables finance company, such as a factoring firm, at a discount to get quick access to those funds. That finance company can then sell those receivables to a securitisation platform, such as Tradeteq, that can pool these assets and make them accessible to institutional investors.
Despite the size of the trade receivables and trade finance market, the securitisation part is still relatively small, with the market for repackagings and trade receivables funds estimated no larger than $15bn-25bn. Many of these securitisation can throw off a yield of around 1% a month with the underlying receivables usually paid off within 90 days. These yields have attracted some leading private credit investors, who run specialist funds to capitalise on this opportunity.
So what’s the catch?
Given the attractive risk-adjusted returns - why aren’t non-bank financial investors flooding into this market and driving down yields?
Most trade receivables securitisations are un-rated, this filters out most institutional fixed income investors as they have investment-grade only mandates. Tradeteq plans next year to introduce credit ratings for these vehicles - more on that shortly.
The other major factor relates to opaque data, which sets up an information-based arbitrage. It is challenging for most institutional investors to compile data to model risks relating to MSME trade receivables.
For example, this makes it harder to understand credit risk. Then there’s dilution risk where a buyer, such as Walmart, either only pays the supplier partially or not at all due to order specifications not being met. Another revolves around operational risk - that is staying on top of developments involving 100,000s of invoices. And finally, there is utilisation risk. That means quickly replacing invoices that get settled with new ones so the securitisation vehicle always remains fully invested.
Automation brings scale
The good news is that all the data needed to properly model risks relating to MSME trade receivables already exists. As part of their due diligence, trade receivable finance companies already have considerable historic and current data on the companies whose invoices they’re buying. These firms also administer these invoices, such as collecting funds from buyers when they come due for payment.
Instead, the big challenge has been to gather all that data and stay on top of changes in the status of 100,000s of invoices. Tradeteq sources deal flow from multiple originators and uses their data to analyse the underlying receivables assets.
Strong relationships with so many originators means that multi-year securitisation vehicles can be kept topped up with new receivables as old ones mature. This is only possible with automation, which can continuously process and make sense of 100,000s of data points from different originators and receivables.
It is the use of all this technology that makes it possible to generate attractive risk-adjusted returns for investors. For example, of the $3.8bn of trade receivables and trade finance securitisation that Tradeteq has issued, involving over 5mn instruments, there has only been 3 basis points worth of losses.
The low loss rate is the result of effective risk modeling. And when defaults do occur, mitigants like credit insurance and the ability to quickly recover assets help minimise losses.
Credit rating plans
From next year, there are plans to make these assets available to investors with investment-grade only mandates. This will be done by tranching assets into different risk buckets with a range of credit ratings as happens with other securitisations.
However, this has not been practical until recently. Traditionally, first loss investors bear the residual risk, including unpredictable factors like credit dilution, operational uncertainties, and utilisation risk. That made these investors hesitant to take on these exposures due to the difficulty in quantifying such risks.
But now the technology is in place to streamline the origination of trade receivables from multiple sources. This ensures high utilisation rates and the ability to mitigate operational risk thanks to better transparency and advanced analytics. Reducing these unknown variables makes it easier for first loss tranche investors to measure the risks they’d be taken on. This development makes it possible to provide tranches for investors seeking investment grade paper.
The rise of tech enabled capital
This is a great example of how tech is opening up more asset classes to the securitisation market and bringing not just more choice to institutional investors but also channels much needed liquidity to underserved SMEs.
Article by Christoph Gugelmann, CEO & Co-Founder, Tradeteq
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