Diversification is often the key to success for investors and that can mean looking beyond traditional asset classes like private equity and private debt. Of the many instruments out there, trade finance notes are becoming a very attractive alternative for investors looking for consistent (and high) yields. Pushkar Mukewar, CEO of Drip Capital, sat down with ABF Journal to give a wide-ranging overview of this asset class by pulling from Drip Capital’s experience in the marketplace.

What are trade finance notes and how do they work?

Pushkar Mukewar: Essentially, trade finance notes, which are issued through our notes program, are short-term in nature, less than one year, and are backed by trade finance assets, which we originate. They provide stable interest from cash flows of the underlying pool of the trade finance receivables. Given that the assets we originate are short-duration, self-liquidating, and have solid historical performance with attractive returns, trade finance notes provide a great option for investors seeking less volatility for a short-duration asset.

Historically speaking, how has the market for these notes performed? How has that changed recently, particularly in the first half of 2021?

Mukewar: It largely depends on the performance of the underlying pool of receivables which are backing those notes and different kinds of credit enhancements provided by the structure. Since the inception of our note program back in 2017, we’ve issued about $150 million of notes. Our notes program has shown solid performance to date — we’ve had zero principal loss and have never missed a monthly interest payment. This is also because trade receivables have been historically a very high-performing asset class. As a result, it’s a low-risk, recession-proof asset compared to other fixed income and private credit assets.

When you think about the 2008 financial crisis, the default rate of short-term trade receivables was nearly 20 basis points with a recovery rate of over 50% on that. In contrast, asset classes such as consumer loans or credit card debt didn’t perform well in the 2008 crisis.

When I think about how the performance has been in the first half of 2021, I would say that the receivables’ performance has been immune from the recent market volatility. It has continued to show solid credit performance trends at par with pre-pandemic 2018 and 2019 vintages. That default rate for trade receivables remained below 0.03%, and we’ve not seen any drastic change in performance even now.

Just given the recent container shortage combined with the global pandemic, what we’ve seen is that the asset issuance fell slightly below the forecast, primarily because of trade disruption. However, we expect the volume to rebound in the latter half of the year and reach pre-COVID levels in 2022.

What kind of yields due these notes provide to investors and how does that compare with yields from other alternatives?

Mukewar: Investors have access to short-term notes typically: three-month, six-month or 12-month notes. Net returns for investors in the notes program have been in the mid to high single digits. As a contrast, when we compare yields for high yield corporate bonds, with an effective duration of between seven and 10 years, the yields tend to be in the 4% to 6% range, and when you look at a short duration [certificate of deposit], the yield is 17 basis points. So from that standpoint, notes backed by trade finance assets have provided a better risk-adjusted return to investors who seek a short duration and relatively low correlated asset class to the broader markets.

Why are these notes a good alternative to private equity, private debt and other alternative assets?

Mukewar: Most private equity funds have a minimum of three- to five-year lock-in. Private debt funds also tend to have a long-term lock-in because the underlying assets are not self-liquidating like the trade finance assets. When we think about traditional hedge funds, most of them have mostly underperformed the market because of growth in ETF investing. Historically, access to trade finance has been problematic since banks typically keep these assets on their balance sheet. As a fintech player like us, we are trying to originate these assets by directly working with exporters and importers and then offering them to investors backed via a diversified pool of receivables. I would say that compared to some of these other asset classes, this is the advantage. We are basically able to offer attractive returns through short-duration, historically high-performing assets.

How do these notes come into play (or how might they come into play) for asset-based lenders and other secured finance providers?

Mukewar: Banks and other lending institutions have increasingly seen setback lending of trade receivables as a very viable solution for closing the trade finance gap and participating in this attractive risk-return, which is offered by trade receivables. Most of the ABL transactions require sophisticated pricing and underwriting tools. Our comprehensive credit and collection policies are very supportive of such transactions. Most of these ABL investors are looking for scale, so we have to ensure that we build an engine to originate assets that can scale. There are many synergies here, and these notes can play very well with other ABL players.

What kind of demand is there for these notes in the current market? How do you expect that to change over the second half of this year and into 2022?

Mukewar: We’ve seen very strong demand in the past, as well as in recent months. Investors today are hungry for yield and low-volatility, short-term assets. Any investor looking for low volatility, short-term investments and high yields sees this as a suitable asset class. Given the current low-interest-rate scenario and excess liquidity in the market, we expect strong demand for these notes, even going into 2022.

We’ve seen quite a bit of volatility in the supply chain this past year and a half. How do changes in the supply chain affect this type of instrument, if at all? 

Mukewar: Our core business provides working capital efficiency to sellers in emerging markets, such as India and Mexico, through receivables factoring. These sellers are working with buyers in over 50 different countries, the predominant focus being U.S.-based buyers. By having a diversified portfolio, we can navigate changes in the supply chain. So, for example, we definitely saw a spike in more non-cyclical industries like food and packaged food exports during the early months of COVID, and they have remained elevated. On the other hand, we’ve seen a decline in sectors like apparel. Still, overall, our notes program was not impacted because we had a highly diversified portfolio and having that diversified portfolio is essential.

Are there certain types of investors that find (or might find) these types of notes particularly attractive? If so, which types and why?

Mukewar: They have a broad appeal and I think what matters is the scale and size. Generally speaking, we’ve seen appeal from, or interest from, investment managers, endowments, insurance companies, banks, and high net worth individuals and family offices. Basically, anybody seeking yield and short-duration assets is showing interest. As we scale and our note program will continue to expand, these endowments and insurance companies become more viable targets. Today, they are showing interest, but as we scale up, the interest will only increase for them.

Taking a step back, how has the trade finance market fared overall during the last 12 months and how do you expect it to perform during the rest of 2021?

Mukewar: Default rates for trade finance receivables have been well below 0.1%. Even in the middle of the recent pandemic, credit performance remains strong. Specific sectors have fared better than others and there’s a flight toward quality, but during the rest of 2021, I don’t expect any change. COVID is sort of a way of life now, and we don’t expect the credit performance to change particularly. I think it’s been strong and will continue to be strong.