Filling the data gap

Micro and SME finance: risk and return

November 20174 min readFinancial InclusionMicrofinance, Risk

Building on comprehensive data from its 14-year investment track record, responsAbility has presented the first rating for micro and SME finance portfolios.

Micro and SME finance investments have frequently had to struggle against the perception that development investments are riskier than traditional investments. This view is partly based on a data and knowledge deficit.

More sovereign creditworthiness ratings

In the past, many key markets for MSME finance did not have a sovereign rating from one of the three big rating agencies. This has changed:

More data available: Most MSME markets now have a sovereign rating.

Over the past 10 years, sovereign rating coverage for micro and SME finance markets has increased from 41 to 61 countries, with 39 countries now rated as investment grade.

More sovereign ratings

Institutional ratings still rare

Such data are more difficult to find on a company level: Only 13 of 252 financial institution debt investees in the responsAbility-managed portfolio are rated by one of the top three rating agencies. This limits the ability of most mainstream investors to properly quantify the level of risk for most development investments.

responsAbility, in turn, can draw on substantial data from its own financing activities and has adopted the approach applied by leading rating agencies, in which the eventual losses are assigned to the year of default.

Realised losses for MSME finance
The shaded areas show average loss rates for securities outstanding in that year, with different colours representing different ratings. The grey line indicates the loss rate under the same methodology for the largest responsAbility-managed MSME finance fund, with projected rate for 2017 shown as dotted line. Source: Moody’s, responsAbility Investments.

By benchmarking our loss data against the loss rates published by rating agencies, we can suggest a tentative rating for our space of investment.

An analysis of financial institution debt investments over the last decade in responsAbility’s longest-standing fund provides an interesting insight into the degree of implied risk.

Spreads: MSME finance > median spreads with Ba-rating
The chart illustrates the remarkable stability of MSME finance spreads compared to conventional EM bonds. The diminished correlation of MSME finance debt to traditional listed assets typically allows it to improve the metrics of any balanced portfolio.

By looking at 1,752 transactions worth USD 3.3 billion, we are able to see that the realised losses of the fund since 2008 (shown as the black line in the chart) lie between the losses experienced by Moody’s B and Ba cohorts.

Spreads equivalent to securities rated Ba3

With the degree of risk quantified, investors are able to compare returns from a portfolio of loans to MSME finance institutions with those of traditional private debt investments or secured loans in frontier markets, EM corporates, etc.

Average credit spreads for responsAbility-managed MSME finance debt funds are currently around 450 basis points, resulting in a portfolio yield of around 7 % in investment currency, or around 6 % in USD (i.e. net of hedging costs).

This bears very favourable comparison with publicly traded securities that have a similar risk profile, rating and duration: median spreads on 1 to 3-year emerging market bonds rated Ba by Moody’s stand at 213 basis points, 236 basis points for EM corporate bonds.

Average spreads on responsAbility MSME finance debt products have kept between the median option-adjusted spread (OAS) recorded by Moody’s for emerging market bonds rated Ba and B.

In 2017, despite a slight decline, the average spread for responsAbility has exceeded that offered on riskier B-rated products.

Higher returns from MSME finance

Some of this strong performance can be attributed to high barriers to entry for deal sourcing, as well as the “liquidity premium” offered by private debt. However, in the latter case this is provided via a “semi-liquid” fund structure, giving investors a more favourable balance overall.

MSME finance debt portfolios also have an attractive risk profile. Sensitivity to rising interest rates is further reduced by having more than 30 % of the responsAbility MSME finance debt portfolio in floating-rate loans, as well as a short average maturity (2.3 years)

Attractive risk profile

Diversification within these portfolios is also high: the average number of countries invested in by four of the largest MSME finance funds stands at 57. MSME finance debt portfolios have little sensitivity to market risk.

While loans are usually valued at cost and held to maturity, linkages between global capital markets and most developing economies are limited. This connection is further weakened by the fact that end customers of MSME financial institutions are drawn from lower income segments of the population.