Four years ago, analysts at Moody's warned that it was risky to sell leveraged loans to individual American investors.
This made a lot of sense. In the US, these loans are usually made to companies lower on the credit-quality scale, and the entire market is opaque, non-public and illiquid, with idiosyncratic contract terms. The analysts said the fund managers who sell these securities in open-ended mutual funds and ETFs could be putting their reputations at risk.
Sadly, it does not look like anyone listened.
Last week, investors sent nearly $1bn into loan funds, the most in more than a year. The majority of this came from institutions, according to EPFR, but individuals were responsible for almost $200m of inflows.
There are currently five ETFs that invest in leveraged loans, according to ETF.com, and last month Reuters reported that two companies are planning to introduce new ones. The two largest are BKLN, an $8bn fund run by Invesco and SRLN, a $3bn fund run by State Street, with the loan selection managed by Blackstone's GSO (engineer of the manufactured CDS default). On the mutual-fund side, Morningstar shows that at least 30 managers offer bank-loan funds, though some of that money is invested in floating-rate bonds.
Back in 2014, Moody's analysts had a nice explanation of loans' popularity:
Investor memories are short, largely ignoring that bank loans traded at less than 50 cents on the dollar as recently as 2008.
Yet their analysis focused primarily on the fact that it takes longer to complete a leveraged-loan trade than it does to settle ETF or mutual-fund trade. While that is a valid metric, it is too narrow, and allows the industry to try to improve settlement timelines ( median time of T+11!), instead of reevaluating the debt's structure or encouraging fund managers to stop marketing it to individual investors altogether.
As the Bank of England would tell you, the problem with using liquid open-ended vehicles (like ETFs and mutual funds) to invest in illiquid assets is not as dry as settlement time. Instead, it is the chance that a negative feedback loop will occur if this currently booming market turns sour. If poor performance in these funds lead to withdrawals, that could lead to even worse performance, and more withdrawals, and so on.
In short, they create the risk of a fire sale, which should be clear to anyone who watched UK open-ended property funds after Brexit.
Some academics have proposed that the process of creating and redeeming ETFs, performed by dealers known as authorised participants (APs), involves arbitrage that would mute a credit-selloff echo chamber. Matthew Bartolini, head of SPDR research for the Americas with SRLN sponsor State Street Global Advisors, touted ETFs' ability to facilitate price discovery for the market.
“It actually has more liquidity options than other fund structures,” he said. Loan ETFs are “providing liquidity to an illiquid asset class.”
But another pair of academics observed last year that times of market stress create an inner “conflict between APs’ dual roles as bond dealers and as ETF arbitrageurs.” They found that traders tend to act as dealers first in those situations:
First, increases in market volatility and bond market illiquidity reduce ETF arbitrage, consistent with the arbitrage effect and its limitations. Withdrawals from arbitrage can be quite large and results in consistent price discrepancies between ETFs and the underlying holdings of corporate bonds. An increase of 1% in the ETF premium generates an increase in AP arbitrage by 50 basis points; however, as market volatility rises, holding fixed the ETF premium, AP arbitrage declines: a one standard deviation increase in market volatility generates a 10% decline in AP arbitrage. Moreover, the decrease in arbitrage sensitivity is asymmetrically larger when the ETF premium is negative. This suggests an asymmetric risk since APs who attempt to correct this relative mispricing would become even more exposed to risks arising from liquidity mismatch.
These funds have the ability to borrow up to a third of their asset value from banks, of course. But that alone can't save a fund in the middle of a meltdown, as we learned from Third Avenue's Focused Credit Fund, which was forced to liquidate in late 2015 after a sudden and unexpected selloff in high-yield bonds.
And it is worth pointing out that the research above focussed on the corporate bond market, which is much more liquid than the leveraged-loan market.
A total of $54.6bn of leveraged-loans traded in secondary markets in March, according to the most recent figures publicly available. The corporate bond market traded an average $33.5bn each day that month. High-yield bonds alone were more active than loans, with a volume of $11.4bn -- again, that's daily. Assuming there were 24 trading days in March, the loan market would have posted $2.3bn of average daily volume.
BKLN follows an index that tracks the largest 100 loans, which means its holdings are more liquid than the rest of the loan market, said Scott Baskind, head of global senior loans at Invesco.
“I think about these loans as being very similar to the very liquid end of the high yield bond market,“ he said.
Questions of credit quality remain, however. Analysts say loans of all sizes carry more risk than they used to, because the covenants that usually protect investors from corporate excesses have weakened. BKLN's seventh-largest holding is debt from Caesars Resort Collection, a casino company whose covenants deteriorated after a private-equity buyout years ago. While the erosion in loan covenant quality has been widespread, investors say, the most aggressive erosion of lender protections have come in deals from private-equity sponsors.
In contrast, SRLN's investments are chosen according to GSO's judgement, not their size. The bright side of such an arrangement is that the fund does not need to invest in debt of companies simply because they have borrowed enough to make it into the index. But that also means it is not constrained by BKLN's requirement to buy secured debt. While the fund plans to buy mostly senior secured loans, its prospectus says it might also buy unsecured debt, or even ”warrants and other equity securities".
The prospectus also describes some of the thinking behind GSO's credit selection. SRLN's last report said it owned more than 250 loans, including those from Neiman Marcus, Four Seasons Holdings and Ancestry.com. The bond documents say GSO looks for companies with a strong market position and cash flow, skilled management teams, and-- hahahahaha, wait for it:
Private equity sponsorship. Often the Sub-Adviser will seek to participate in transactions sponsored by what it believes to be high-quality private equity firms. The Sub-Adviser believes that a private equity sponsor’s willingness to invest significant sums of equity capital into a company is an implicit endorsement of the quality of the investment. Further, private equity sponsors of companies with significant investments at risk have the ability and a strong incentive to contribute additional capital in difficult economic times should operational issues arise.
The ETF also owns loans from SRS Distribution, which we must assume have better terms than its bonds.
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