Monetary policy and regulation post the Global Financial Crisis (GFC) have created a challenging investment environment. In what follows, we narrow our discussion to U.S. debt and money markets and discuss an alternative investment for dollar-based money market investors. A shift to long-duration issuance in the corporate bond market has limited the supply of high quality, short-term investment products. As a result, short-term money investors have been increasingly dependent on investing in bank deposits, U.S. Treasuries (USTs), and Money Market Funds (MMFs). One product for money market investors to consider is confirmed receivable purchases (CRPs), which is a form of trade finance that offers high quality, non-financial corporate credit risk in a short-term, floating rate product.

Bank regulation and monetary policy post-GFC have resulted in a low interest rate environment in traditional debt and money markets today. This has shifted corporate debt issuance from the short-end of the yield curve toward the long-end. A consequence of this shift is an increase in fixed rate, long-term product issuance and a decrease in floating rate, short-term product issuance (Figure 1).

Figure 1. U.S. corporate bonds issuance and average maturity of issuance by year. Figure 1. U.S. corporate bonds issuance and average maturity of issuance by year. U.S. corporate bonds issuance in USD billions on left y-axis; average maturity of issuance in years on right y-axis. Fixed rate issuance grows and floating rate issuance decreases, as the average maturity of issuance rises. Sources: SIFMA and Bloomberg Barclays Index.

In an effort to maintain returns, investors have tolerated increased risks at lower returns as they commit their fixed income investments to low yields for longer durations. Those investors refusing to follow this trend are left with unappealing returns from available short-term products—primarily bank deposits, USTs, and MMFs. The low returns available in short-term products are made even lower by changes in Federal Reserve monetary policy and commercial bank re-regulation, which lead to increased competition from central and commercial banks for access to USTs (Figure 2).

Figure 2. Fed and U.S. commercial bank holdings of U.S. Treasury and Agency securities by year. Figure 2. Fed and U.S. commercial bank holdings of U.S. Treasury and Agency securities by year. U.S. Treasury and Agency securities in USD billions on y-axis. The Fed and commercial banks have increased their holdings of U.S. Treasury and Agency securities over the past decade. Source: Federal Reserve Bank of St. Louis.

To make matters worse, investors have reduced options for investment in MMFs (Figure 3) due to Money Market reform – rules implemented in October 2016 by the Securities Exchange Commission (SEC) as a result of the failure of some prime MMFs to meet redemptions during the GFC [1]. An additional concern for investors is that prime MMFs are highly concentrated in debt instruments issued by financial institutions, specifically commercial banks. This situation has made it difficult for investors to find high quality, short-term credit products that are not exposed to government or financial institution credits.

Figure 3. Government versus prime MMF total net assets by year. Figure 3. Government versus prime MMF total net assets by year. Total net assets in USD billion on y-axis. Due to Money Market reform, prime MMFs total net assets have dropped to about 25% of their 2015 year-end level by year-end 2016. Capital has flowed into government MMFs as a result. Source: ICI.

These market dynamics have created a gap in investment portfolios, leaving unmet demand for floating rate, short-term products, and concentrated exposure to financial institution credits. Many investors are therefore seeking fixed income alternatives. One emerging investment product for investors to consider is trade finance receivables, specifically CRPs. This investment product offers investors the opportunity to invest in high quality, short-term, non-financial credit risk in a floating rate product. These characteristics make CRPs an attractive alternative to bank deposits, USTs, or MMFs for institutional investors.

Trade finance broadly describes activities that involve financing and risk mitigation related to payables and receivables. Account receivable and payable financing is one type of trade finance that is commonly implemented through receivable purchases, loans against receivables, or insurance against receivables. One specific form of this type of trade finance is called a confirmed receivable purchase (CRP). CRPs provide an attractive form of alternative credit investment for investors to consider.

Figure 4.  Example of a confirmed receivable purchase transaction. Figure 4. Example of a confirmed receivable purchase transaction. Source: Fermat Capital Management, LLC.

Figure 4 illustrates an example of a confirmed receivable purchase transaction. An account receivable is created as the result of a commercial trade transaction between a corporate obligor and a supplier. A finance agent, typically a bank, then agrees to purchase the receivable from the supplier early at a discount. In a CRP transaction, the obligor has committed to make payment to the finance agent in full upon maturity. This is the “confirmed” part of the CRP. An investor in turn then purchases the confirmed receivable from the finance agent. Upon the maturity of the receivable, the investor is paid directly by the finance agent on behalf of the obligor.

Despite the short-dated maturity of CRPs, the margin is often better than the margin seen for a much longer-dated corporate bond by the same obligor. In this sense, CRPs “beat the yield curve” of traditional debt instruments.

The risk-adjusted yield of CRPs makes them an attractive credit investment. One way to see this relative value is to compare CRPs with corporate bonds of single obligors. The discount rate for CRPs is structured as a margin over the prevailing Libor. In order to compare an obligor’s floating rate CRP yield spread to their fixed rate corporate bond yields, we calculate the implied corporate bond yield spread by subtracting the appropriate swap rate from the corporate bond yield. For example, if an obligor’s corporate bond has three years to maturity and a yield to maturity of 130 bps, and the U.S. 3-year fixed swap rate is 110 bps, the corporate bond can be calculated to have an implied 20 bps (130 – 110 bps) spread over Libor (L+20 bps).

Using this analysis, CRPs have an attractive margin over Libor versus corporate debt from the same obligor. Figure 5 gives a typical result for a single obligor.

Asset

Years to Maturity

Credit Spread (bps)

Corporate Bond 1

3.93

20

CRPs

0.25

30

Corporate Bond 2

6.44

55

Figure 5. Single obligor, a U.S. consumer goods corporate rated AA- Sample analysis of an AA- U.S. consumer goods corporate obligor (anonymized due to confidentiality) as of 30 Sep 2019. Source: Fermat Capital Management, LLC and Bloomberg.

The CRPs for the obligor in Figure 5 have a typical weighted average maturity (WAM) of 90 days and a margin over Libor of 30 bps. This yield spread is better than Corporate Bond 1 with almost four years to maturity. Despite the short-dated maturity of CRPs, the margin is often better than the margin seen for a much longer-dated corporate bond by the same obligor. In this sense, CRPs “beat the yield curve” of traditional debt instruments.

There are multiple factors driving this attractive relative value. The principal reason is that CRPs exhibit risk-return independence, whereby the pricing for CRPs is not linked to the primary credit risk of the obligor, while the credit risk remains solely that of the obligor. This is because the discount rate at which a finance agent offers early payment to a supplier is driven by a number of factors, including the cost of capital of the supplier, not just the obligor. Referring to the example in Figure 4, Wilmar has a higher cost of capital than Kellogg’s because Wilmar is unrated while Kellogg’s has an investment grade rating. Therefore, investors are paid a higher discount rate than if they were financing to Kellogg’s directly and alone.

Another factor driving the excess spread in CRPs relative to corporate bonds is that CRPs are not rated and are structured as private placement transactions. The non-uniform structures across different asset providers and obligors is a higher barrier to execution relative to corporate bonds, which are public securities with ratings. Investors are thus compensated for this higher barrier to execution through a “liquidity premium”. Put another way, corporate bonds are a “crowded trade” versus CRPs.

The short-term floating rate structure of CRPs also allows investors to diversify away from the fixed rate products and take advantage of the relative attractiveness of Libor based products versus Treasury based products (Figure 6).

Figure 6. TED Spread. Figure 6. TED Spread. TED Spread in % on y-axis. The TED spread measures the difference between 3-month USD Libor and the 3-Month U.S. Treasury Bill rate. The TED spread has historically been positive; this indicates that Libor has been higher than the comparable Treasury Bill rate. Source: Federal Reserve Bank of St. Louis.

Resources:

[1] For more information on the effects of MMF reform, refer to the “Investors’ Appetite for Money-Like Assets: The Money Market Fund Industry after the 2014 Regulatory Reform” by Marco Cipriani, Gabriele La Spada, Philip Mulder from the Federal Reserve Bank of New York.