Illiquidity spreads under pressure: trade and export finance assets offer an attractive alternative

02/07/2018

• Compensation for illiquidity in private markets under pressure from over crowding • Trade and export finance markets offer an attractive alternative source of return • Monetising operational complexity in low credit-risk assets and access stable levels of illiquidity compensation can be beneficial for investors

Investors attempting to enhance returns by moving into less liquid assets are increasingly faced with the challenge of these markets becoming crowded. The scale of demand creates significant pressure on spreads, which in turn makes it harder to maintain the reward for that additional illiquidity at an adequate level, especially with the turn in the credit cycle looming large on the horizon. The issue is only reinforced by the increasing cost of liquidity in plain vanilla bond markets - liquidity which later often turns out to be little more than a mirage. Fortunately, there are still deep markets available offering enhanced returns by capturing a robust and consistent illiquidity spread without adding exotic new risks, according to NN Investment Partners (NN IP).

If one of the unintentional consequences of recent financial regulation has been to impair market liquidity whilst increasing overall levels of debt, another has been to create downward pressure on illiquidity compensation in private markets by making illiquidity itself an attractive risk premium. This has broadly caused loans to be in high demand, pulling issuance spreads of these less liquid, more complex asset classes closer and closer again to their liquid counterparts.

Suresh Hegde, Head of Investment Solutions at NN Investment Partners, commented: “If investors once turned to illiquid assets because they were overpaying for ‘mirage liquidity’ in standardised markets, they now increasingly find themselves undercompensated for actual illiquidity in private markets.”

The compression of spread has not been uniformly observed, however, with some private markets continuing to show relatively stable illiquidity compensation, even in the wake of the great wave of money being put to work in the search for yield. For those looking to benefit from monetising illiquidity in new asset allocations, identifying the underlying forms of complexity that drive the illiquidity in a market is key.

Trade and export finance are good examples of markets in which this complexity is both a) controllable, and b) more likely to be persist in the future. Crucially, the fundamental credit risks are alike those in standard corporate and government bonds, i.e. the additional spread compensation versus liquid bonds relates to structural and operational complexity only, and not hidden or esoteric market risk.

 “These assets offer a compelling and substantial opportunity for investors looking to increase returns by harnessing operational complexity in low credit risk investments, where they can also benefit from very low capital costs.”

Given the investments are also either longer-dated and AAA-rated (as in the case of government-guaranteed export finance), or in the case of trade finance are BBB/BB-rated with very short maturities of less than 180 days, they also offer conservative positioning in a turning market. Guaranteed export loans can be used as a defensive, better-yielding substitute either for government bonds or investment grade credits, and short-dated trade finance loans as a capitally-efficient credit or even a yield-enhanced cash substitute.

“Thanks to both the size and nature of the markets, the risk of standardisation is also lower and illiquidity compensation therefore more stable. The operational aspects may sometimes be burdensome, however, so partnering with counterparties with lengthy experience and specialised infrastructure is key to ensuring the investment strategy will be robust and repeatable.”

Together, the features of trade and export finance offer a compelling opportunity for investors being forced out of other asset classes due to over-demand and falling complexity compensation. This is particularly true given their scale – the global market for trade-based lending is USD 16 trillion[1].

Sources:
[1]
World Trade Organisation, trade statistics and outlook, 7 April 2015, www.wto.org

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    About the author

    Suresh Hegde

    Suresh Hegde

    Head of Insurance Solutions & Alternative Rates

    Experience since 2000

    Business Experience

    2014-to date Suresh is Head of the Insurance Solutions & Alternative Rates team within the Balance Sheet Management Boutique of NN Investment Partners. He is responsible for the origination and structuring of bespoke LDI solutions for insurance and pension clients within an accounting and regulatory capital aware framework. Next to that he is Lead PM for Alternative Rates, including ECA loans, government related loans and structured rates strategies.

    2011-2014 Senior Portfolio Manager, Structured Investments at ING IM

    2010-2011 Senior Consultant, Financial Consulting at Europel Group, London

    2007-2008 Associate Director, Credit Derivative Structuring, at JP Morgan / Bear Stearns, London

    2006-2007 Vice President, Credit Derivative Structuring, at Bear Stearns, London

    2004-2006 Associate, Credit Derivative Structuring, at Dresdner Kleinwort Wasserstein. London

    2002-2004 Ratings Specialist, Portfolio Ratings at Standard & Poor’s, London

    2001-2002 Analyst, Strategy, at Linklaters, London

    Qualifications

    BSc in Politics from The University of Bristol, UK in 2000

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