Yahoo Finance Fear Not: Bank Loan Alternatives Exist
For those who fear the leveraged-loan market, alternative exposures exist.
This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Clayton Fresk, CFA, portfolio management analyst at Georgia-based Stadion Money Management.
Last month at ETF.com’s Inside Fixed Income conference, much of the conversation surrounded the overwhelming success of bank-loan ETFs as a fixed-income alternative.
However, the flip side of the conversation was the trading characteristics and potential illiquidity of the underlying loans, particularly in times of market distress. While there are distinct advantages to holding loans as part of an allocation, there may be alternatives in the market to capture similar exposures.
Positive For Loans
Firstly, there are characteristics of leveraged loans that make them an attractive alternative to other fixed-income products. One positive is that loans sit higher in a company’s capital structure than do bonds.
This is an important distinction in terms of recovery rates after defaults. While high-yield bond recovery rates hover around the 35 percent level, recovery rates in the loan space are more toward the 75 percent range.
Another positive is loans offer a floating-rate coupon versus bonds, which have a fixed rate. Coupons are pegged to a spread over a floating rate—usually three-month Libor. So loans have the attractive feature of having essentially zero duration, which can be a very compelling feature to those who fear we are on the precipice of a rising-rate environment.
Tying into this last point, because leveraged loans normally sit below investment grade, they offer a higher yield than other floating-rate instruments. Here’s a yield comparison of three different floating rate indices as of Oct. 28:
S&P Leveraged Loan 100 Index: 4.85 percent
Barclays US FRN < 5 Years Index: 0.56 percent
Barclays US Treasury Floating Rate Index: 0.06 percent
Lastly, the loan market has become increasingly accessible via the ETF market, both in terms of the number and size of the loan ETFs available. Liquidity in the ETFs themselves has become deep, and I’ll touch on that later.
Negatives For Loans
One of the major differentiators and a cause of worry for many contemplating a loan allocation is the trading characteristics of the underlying loans themselves.
Unlike corporate bonds, which have a very normalized and streamlined T+3 settlement process, the loan settlement process is quite the opposite. The settlement time is not standardized, so it can vary from T+10, T+20, etc. Also, delivery is much more of a cumbersome, manual process as compared with bonds.
As such, the loan ETFs don’t carry the in-kind creation and redemption feature as do most other ETFs; instead, they make use of cash creation and redemption, which can be another negative when comparing loan and bond ETFs.
Another negative in the loan space is a potential lack of liquidity in times of market distress. While the same can be said for other asset classes, such as high-yield bonds, worries in the leveraged loan market are greater—whether perceived or real—because of the aforementioned trading characteristics that the leveraged-loan market is more apt to suffer from a liquidity crunch in a sell-off.
Heightened Volatility
Similar to an investment-grade versus high-yield bond comparison, leveraged loans experience greater volatility and equity correlations than their floating-rate counterparts. Although having a near-zero duration, leveraged loans have a higher spread duration. That means they’re still subject to price fluctuations based on spread movements.
Following is a quick comparison of the weekly standard deviation and correlation to the S&P of the bank-loan and floating-rate corporate indices from above over the past three years:
Standard Deviation:
HY Leveraged Loans: 2.01%
IG Floating Corporate: 0.37%
Correlation:
HY Leveraged Loans: 0.44
IG Floating Corporate: 0.22
Loan Alternatives
The main question investors need to ask themselves when determining loan alternatives is why a loan allocation is wanted in the first place.
If the main reason for the allocation is to obtain high-yield-type spread exposure without having the associated duration exposure inherent in fixed-rate bonds, then an alternative may lie in the growing number of interest-rate-hedged high-yield ETFs available.
These ETFs use interest-rate futures to hedge the duration exposure, leaving only the spread exposure remaining.
These ETFs include:
Ticker | Issuer | AUM | 30-Day Volume | Hedge Mechanism | Spread Duration |
THHY | Market Vectors | 9.9M | 670 | 5-year futures | 4.3 |
HYHG | Proshares | 160.8M | 23600 | 2-, 5- and 10-year futures | 4.1 |
HYGH | iShares | 43.5M | 8000 | 2-, 5-, 10- and 30-year futures | 3.7 |
HYZD | Wisdomtree | 22.0M | 10500 | 2- and 5-year futures | 2.3 |
So while the number of ETFs available is growing, the market has been slow to use these funds based on the assets under management (AUM) and volumes seen above.
The names above have subtle differences. While most have spread durations in the four-year range (which is comparable to the spread duration of the PowerShares Senior Loan Portfolio (BKLN | B)), the WisdomTree BofAMerrill Lynch High Yield Bond Zero Duration Fund (HYZD | C-61) is lower, at 2.3 years.
This is a function of the underlying index for HYZD being a 0-5 Year High Yield index, whereas the other names have broad high yield as their index.
In addition, the hedging mechanism varies in the tenors of interest-rate futures used. The broader the range of futures used will allow for more accurate hedging across the curve and has less of a chance of changes in the shape of the yield curve affecting returns.
If determined that the allocation preference is loans rather than rate-hedged bonds, there are also a few different ETFs to choose from with varying exposures:
Ticker | Issuer | Passive/Active | Index/Advisor | $ AUM | 30-Day Volume | YTD TR thru 10/28 | Spread Duration |
BKLN | PowerShares | Passive | S&P/LSTA LL 100 | 6.3B | 3.6M | 0.90% | 4.2 |
SNLN | Highland | Passive | Markit iBoxx USD Liquid LL | 315.4M | 293.9K | 1.35% | 4.2 |
FTSL | First Trust | Active | First Trust | 200.7M | 32.6K | 1.31% | 4.8 |
SRLN | State Street | Active | Blackstone/ GSO | 598.2M | 96.3K | 0.97% | 4.8 |
While BKLN continues to be the behemoth in the space, the other names continue to grow in both AUM and volume. There is also a mix of passive and active names in the space.
For those who may be hesitant to allocate to the loan space based on liquidity concerns, active management may be an answer, as the fund managers may have the discretion to use liquidity as a consideration when choosing the underlying investments.
Additionally, it appears the success of BKLN may also be a slight hindrance as well, as the fund is lagging its index on a year-to-date basis, by 76 basis points. Some of this dispersion may be cash drag. That’s because managers must consistently put subscription money to work, but may be more limited on the use of nonloan assets they can use (i.e., bonds) to proxy exposure while sourcing loan liquidity.
Conclusion
There are both positives and negatives to investing in the leveraged-loan market.
For those who feel the positives outweigh the negative, there are a number of ETFs available. However, for those who like the return profile of loans but feel more comfortable allocating in the bond space, interest-rate-hedged ETFs could be the answer.
At the time this article was written, the author’s firm owned shares of BKLN on behalf of clients.
Founded in 1993, Stadion Money Management is a privately owned money management firm based near Athens, Georgia. Via its unique approach and suite of nontraditional strategies with a defensive bias, Stadion seeks to help investors—through advisors or retirement plans—protect and grow their “serious money.” Contact Stadion at 800-222-7636 or www.stadionmoney.com. References to specific securities or market indexes are not intended as specific investment advice.
