At its core, trade finance is a loan that funds the sale or purchase of goods across borders. The structure of that loan can take many shapes – including letters of credit, factoring, direct lending and, in recent years, supply chain finance - but the practice is as old as banking itself, reaching back to ancient times. Kowit, a financial history enthusiast, pointed out that sections in the Code of Hammurabi lay out rules governing trade finance.
Unlike corporate debt, which has the tendency to fund speculative buyouts or be used for “general corporate purposes,” trade finance is almost always tied to a specific transaction – for example, the export of a couple containers of machinery from the US to China or the shipment of entire boat load of soy beans from Brazil to the US. In that sense, trade finance loans are both collateralized and self-liquidating. Once the sale is complete, the loan is paid off.
Global trade volumes are projected to rise to USD 150 trillion in 2030 from about USD 37 trillion last year, according to a June economic outlook report from Citigroup. In the US, the Obama administration announced in 2009 its aim to double the country’s exports in five years, bringing export volume to roughly USD 3.14 trillion by 2015. And nearly all of those transactions will need financing.
At the same time, Basel III, a set of new global banking regulations that start to phase in next year, could constrain the ability of traditional banks to finance the movement of goods across borders. The Basel Committee on Banking Supervision, the governing body that sets the standards, allowed for slightly less restrictive capital requirements for trade finance in late October, but regulations governing other forms of banking – such as swaps – could impact the overall capacity of banks to lend to international trade transactions.
Federated Investors pitching trade finance strategy
By Anthony Kim
Trade finance is one of the oldest forms of banking and despite its many attractive characteristics, has never taken off as an investment for money managers.
Federated Investors, the Pittsburgh-based investment manager with around USD 350bn in assets, is aiming to change that dynamic. Robert Kowit, the firm’s senior vice president responsible for the trade finance initiative, said that Federated would pursue outside institutional investors for a trade finance strategy it has honed and perfected over the last six years.
At its core, trade finance is a loan that funds the sale or purchase of goods across borders. The structure of that loan can take many shapes – including letters of credit, factoring, direct lending and, in recent years, supply chain finance - but the practice is as old as banking itself, reaching back to ancient times. Kowit, a financial history enthusiast, pointed out that sections in the Code of Hammurabi lay out rules governing trade finance.
The traditional source of trade finance has been banks, with the large bulge bracket firms financing large military sales or massive commodity shipments while the smaller regional banks fund local manufacturers. And it has been an attractive asset class for banks.
Unlike corporate debt, which has the tendency to fund speculative buyouts or be used for “general corporate purposes,” trade finance is almost always tied to a specific transaction – for example, the export of a couple containers of machinery from the US to China or the shipment of entire boat load of soy beans from Brazil to the US. In that sense, trade finance loans are both collateralized and self-liquidating. Once the sale is complete, the loan is paid off.
And if there is a default, for example if a buyer refused to post payment for the shipped goods, the lender can simply sell those goods elsewhere to be made whole. But trade transactions rarely get to the point of a default, said Kowit. There are a number of safeguards that are normally put into place to protect the lender.
“The thing that makes trade finance so unique is the transactions are in place aimed at mitigating very specific slices of risk,” Kowit said. Insurance is taken out against the damage of the goods while they are being shipped, collateral monitoring agents are hired to look after the goods while they are being warehoused and back-up off takers are found in case the original buyer balks and refuses to pay, said Kowit. And every slice of insurance is paid for by the importer and exporter, not the lender, Kowit said.
Trade loans also have shorter tenors, decreasing the duration risk for investors. Depending on the sector, the average payment period runs between 90 to 120 days with longer transactions taking 18 months before they are paid off.
Even with the short duration, trade finance loans are usually lent on a floating rate basis, which can offer investors interest rate risk over time.
Default rate lower than all other forms of debt
Trade finance loans are historically considered safer investments and thus have narrower yields than leveraged loans or high-yield bonds. However, trade finance was actually yielding higher than leverage loans at the height of the market before loans started to sell off in 2007, Kowit said. Even so, the default rate for trade finance remained lower than all other forms of debt, he said, adding that the strategy’s returns have been good.
Between 2005 and 2009, only 1,089 trade finance transactions defaulted out of 5.2m transactions from nine leading international lenders, for a default rate of about 0.02%, according to a study conducted by the International Chamber of Commerce and the Asian Development Bank. This is comparable to the long-term average default rate for companies rated AA by S&P, according to a report by UK-based Equity Development in April this year.
Federated’s internally run strategy was up 2.06% for 3Q11, Kowit said. The strategy is up 5.43% year-to-date, up 6.95% for the one-year-trailing period and is up 6.95% since its inception in April 2010, he said.
So why, then, has trade finance never been a popular investment asset despite these advantages?
According to Kowit, the problem has always been “mechanical.” By this he was referring to the relatively large amount of paperwork documenting these transactions and the employees that keep track of that paper, otherwise known as the “back office” in the financial industry.
The business is not easily scalable, as well, Kowit pointed out. A firm can expand its capacity to analyze and invest in trade finance deals, but because many of these deals are small, additional employees can only expand investing capabilities so much. Compare analyzing a trade finance deal, which can often range in the hundreds of thousands of dollars, to the USD 200m minimum value that a typical CLO,analyst would put in place before looking at a deal.
A number of trade bankers who declined to be identified pointed to one key problem which had limited financial institutions’ enthusiasm for the business : the return on investment for the amount of time and work needed to build a sizable and high-yielding portfolio was insufficient. The idea of setting up a system has been around for decades, for sure, but has yet to take off.
Still, Federated Investors began pitching such a strategy to large institutional investors earlier this year. The firm’s biggest advantage, according to Kowit, is its years of experience in the field and the fact that it possesses a team that can monitor every aspect of these trade transactions. Over the last 12 months, Federated Investors has looked at 600 transactions, wrote up analysis on 150 of those and finally invested in about 100, Kowit said.
The new strategy is a version of one that the firm has been running internally since November 2005, which has been open only to its own portfolio managers, Kowit said. Federated Investors made the strategic shift this year to open the strategy to a broader group of institutional investors, including pension funds, insurers and mutual funds, Kowit said.
The strategy is diversified by sector and geography with some duration difference, he said. The firm also targets deals in the Libor + 400bps-600bps range, Kowit said. That is somewhat of a midpoint between the large high-quality deals that typically yield Libor + 60bps-90bps and the smaller high-risk loans that can be priced upwards 10% for less than one year paper, said industry bankers that declined to be named.
The strategic shift comes at an opportune time. Global trade volumes are projected to rise to USD 150 trillion in 2030 from about USD 37 trillion last year, according to a June economic outlook report from Citigroup. In the US, the Obama administration announced in 2009 its aim to double the country’s exports in five years, bringing export volume to roughly USD 3.14 trillion by 2015. And nearly all of those transactions will need financing.
At the same time, Basel III, a set of new global banking regulations that start to phase in next year, could constrain the ability of traditional banks to finance the movement of goods across borders. The Basel Committee on Banking Supervision, the governing body that sets the standards, allowed for slightly less restrictive capital requirements for trade finance in late October, but regulations governing other forms of banking – such as swaps – could impact the overall capacity of banks to lend to international trade transactions. |
