In May, debate erupted when Laurence Fink, CEO of BlackRock, the world’s biggest ETF manufacturer, said that his firm would not be packaging bank loans into an ETF as the liquidity mismatch between the ETF vehicle and the underlying loans represent a structural risk. This structural risk could lead to performance that can meaningfully deviate from what investors expect. But steady returns can be a great pacifier for debate and senior bank loan ETFs continued to climb throughout June. However, with a high velocity sell-off in the last week of July, the debate has re-emerged.
What are Bank Loans?
In the world of fixed income, yield primarily compensates two sources of risk. The first is duration risk – which captures the time-value of money. The second is credit risk – or the risk of default. U.S. Treasuries, which are considered to have little-to-no credit risk, give varying levels of “pure” duration risk based on maturity. The floating rate debt of very risky companies, on the other hand, gives near-pure credit risk exposure. These loans have a coupon rate that floats above LIBOR and resets the coupon on a fairly short-term schedule – usually 30, 60 or 90 days – providing very little sensitive to rate changes.
Low current rates and the probability of rising rates in the future has been a one-two punch to the traditional income generating portfolios of yesterday, forcing investors to explore alternative means of generating yield. With the economy in recovery – an indicator of decreasing default rates – the higher yield and low duration sensitivity of bank loans have drawn the attention of many investors. So much so that The PowerShares Senior Loan Portfolio (BKLN) was awarded the William F. Sharpe ETF Product of the Year in 2013.
But have investors been lured by a siren’s song?
Bank Loans versus High Yield
Beyond the resetting coupons (“floating rates”), the difference between senior bank loans and high yield can is summarized in the senior part of the name. Traditionally, they are the highest-priority credit on a firm’s balance sheet, meaning they get repaid before any other type of debt or financing. Furthermore, senior loans are typically collateralized by firm assets – assets which are unclaimed by any other debt – meaning that in the case of a default, the assets will be liquidated to repay the senior loans before any other collector sees proceeds. Combined, these aspects actually make senior loans less risky than traditional high yield bonds, and thus they tend to command a lower yield.
That being said, companies issuing senior bank loans may be doing so because they are already highly indebted or unable to issue debt in a traditional way, meaning they have much higher credit risk. BKLN has approximately 40% of the portfolio in B-rated debt; the SPDR Senior Loan ETF (SRLN) holds approximately 50% split evenly across B+ and B. These credit ratings have mean default rates of approximately 7%.
Managing Expectations: An Issue of Education
These products have some peculiarities and idiosyncrasies which may catch investors off guard. The rate of the loans are a spread against LIBOR rates. So if a loan is L+400 – or LIBOR plus 400 basis points – with 3-month LIBOR at 0.26%, the coupon rate would be 4.26%. To prevent against ever-falling LIBOR rates – which would cause yields to reset lower – these loans often have a floor, meaning that when LIBOR falls below a certain level, the lender receives the floor rate instead. When LIBOR falls well below the floor, however, there can be a gap in floating behavior of the yields until LIBOR climbs back above the floor. When LIBOR is significantly below the floor, the loans can have a sensitivity to interest rates more in line with a traditional fixed-coupon bond.
Currently, SRLN’s weighted average LIBOR floor is approximately 1% and the 3-month LIBOR rate sits near 0.26%, meaning that bank loan portfolios may suffer interest-rate sensitivity based losses from rising rates until the floor is eclipsed.
Managing Expectations: An Issue of Structure
Volume of an ETF is not necessarily a good proxy for liquidity of an ETF. The best proxy is to look at the liquidity of the underlying securities. An ETF will generally trade in a range around its fair value – typically taken as the net-asset-value of the underlying securities. As demand bids up price above fair value, authorized participants (APs) enter the market and sell shares at the premium price and simultaneously buy the underlying securities. At the end of the day, the APs will deliver the underlying securities to the fund family and receive shares of the ETFs at fair value. This action allows them to lock in the premium differential they captured earlier in the day. So while price will dance around fair value throughout the day, it is normally limited to certain arbitrage thresholds.
Typically, in highly liquid markets, the price-to-NAV differential remains low because arbitrage is cheap (e.g. the SPY ETF versus the S&P 500 stocks). In less liquid markets, the differential can grow because the arbitrage limits are riskier; consider ETFs that hold emerging market equities that may not trade during U.S. market hours.
So what happens when investors want to trade an ETF and the underlying assets have gone insane or frozen entirely? Without a liquid market in the underlying securities, APs may not be able to set their arbitrage bounds with confidence, so they may sit on the sidelines. Since ETF investors can buy and sell to each other in the secondary market without impact on the underlying market, ETF price can deviate meaningfully from NAV. Some point to these meaningful discounts and premiums as inefficiencies that can be harmful to ETF investors. However, others argue that when the underlying assets freeze, the ability for the ETF to continue trading means that the ETF “becomes” the market: the ETF price actually becomes a more accurate representation of value than NAV.
As a point of comparison, we should also consider the equivalent mechanism in mutual fund packaging: when an investor goes to sell her mutual fund, she submits a sell order and receives NAV, forcing the portfolio manager to liquidate holdings to raise money. Forcing the manager to sell into a potentially frozen market can create a fire-sale scenario that may result in prices that hurt the entire fund’s NAV. In this sense, the ability for ETF investors to trade in a healthy secondary market can potentially limit fire-sale events.
This is how ETFs work in broad strokes. With bank loans in particular, sales and purchases occurring in the underlying interest in the syndicated loan facility can take weeks to settle, include the transport of physical documents. But portfolio managers have embedded several mechanisms in these funds to manage these risks, including (1) the ability to hold a significant portion of assets in cash, (2) the ability to hold a significant portion of assets in bonds, and (3) the ability to establish credit facilities as a source of liquidity. These three mechanisms, used in extreme scenarios, can enable liquidity at the cost of divergence. As a last ditch resort for solvency, some funds have the ability to return assets in kind — meaning the investor that sells the ETFs would receive a basket of the underlying loans and be forced to sell the loans themselves.
Bank loans are fairly illiquid junk bonds – they are speculative in nature and should be considered as such in a holistic portfolio view. The convenience of bank loans in an ETF package comes with its own set of risks – and potentially costs – that investors should be aware of. We have to ask ourselves, “does the access to a unique asset class profile outweigh the risks?” We believe that with realistic expectations and prudent portfolio construction, bank loans can play an important role in generating income.
Despite the velocity of recent sell-offs, our proprietary models still label bank loan ETF drawdowns within the thresholds of regular volatility levels around a long-term positive trend. With most market participants agreeing that there is little risk of an impending recession and yields in U.S. Treasuries projected to rise in the next year, the current discount to NAV in bank loan ETFs like BKLN and SRLN may be a great entrance point to generate both yield and diversification in a portfolio.
Note: Newfound utilizes the PowerShares Senior Loan Portfolio (BKLN) ETF in its Newfound Risk Managed Income strategy. Newfound encourages investors to seek the advice of a financial advisor as the appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.