Among the various asset classes, trade receivables securities normally perform well even in trying economic times. One of the main reasons for this is that the trade receivables receive credit enhancement: they are separated from the seller and given reserves that result in higher credit ratings when used in securities. Thus, an unpaid invoice when it is securitised gains a higher credit rating than the company that issued the invoice. This post will look in detail at these credit enhancements.
To understand why trade receivables become more attractive to investors once they are securitised, it is important to look at reserves. Credit loss reserves refers to money set outside to mitigate risks of non-payment or slow payment of the invoices that have been collateralised. Complex formulas are used to calculate reserve rates.
A dilution is a technical term that means that trade receivables are impaired not because of payment issues by the obligor (company who has to pay the invoice), but because of other issues such as product defects, erroneous billing and volume discounts. A dilution reserve is included into trade receivables securitisation to mitigate against the risk of dilution.
Another type of reserve is yield reserve. Unlike other assets, trade receivables are not interest earning. However, securities have interest paying liabilities. To allow for interest trade receivables are bought at a discounted price. The discount is to pay for yields and fees. The difference between the real value of the trade receivables and the purchase price is the yield reserve. When interest rates are low, this reserve is small comparative to credit loss and dilution reserves.
Another way that the process of securitisation of trade receivables reduces risk and enhances value is by looking at the concentration levels for obligors. A limit is set on the number of unpaid invoices that can be bundled into securities from any one debtor. This is determined by the credit ratings of the obligors involved.
Trade Credit Insurance
This term refers to insurance for trade receivables where there is a specific reason to fear that an obligor will default on its payment. Trade credit insurance is another strategy to enhance the value of trade receivables securities. Typically, trade credit insurance is used when there are high concentrations of certain obligors or where the transactions are carried out in countries deemed riskier than in developed countries.
While sellers or issuers sell their trade receivables and are legally separated from the ensuing securities, they are still required to make legally binding warranties on their invoices. This is to provide protection against fraud, dilution and misrepresentation.
Finally, risk is mitigated by a robust regime for monitoring and reporting on the status of the trade receivables that have been deemed eligible for securitisation. The assets are relatively short-lived and as a consequence the composition of trade receivables used in securities is continually changing. The seller is tasked with tracking payments, providing details of new trade receivables, applying eligibility criteria, calculating reserves and concentration limits etc. Through careful monitoring and reporting the quality of the trade receivables securities can be maintained.
It is not the case that the company holding unpaid invoices simply sell these invoices to another company specialising in trade receivables securitisation and have no further involvement. Although, they no longer legally own the receivables they are still contractually obliged to monitor and report on the composition and nature of receivables involved in the resulting securities.
Moreover, the securities are structured with a series of reserves to protect against a fall in market value. Warranties and trade credit insurance is also used to mitigate against various risks including non-payment, fraud and large currency fluctuations.