Are Bank Loan ETFs Turning The Corner?

Bank loan ETFs may be finally breaking to the upside, thanks to waning fears of default in leveraged credit markets, wider spreads and attractive yields.

Last year, ETFs such as the PowerShares Senior Loan ETF (BKLN | C) and the SPDR Blackstone / GSO Senior Loan (SRLN | C) ended the year with losses of 3% and 1.3%, respectively. On a rolling-12-month basis, these funds remain in the red, as the chart below shows:

But a look at year-to-date performance for 2016 shows that the trend seems to be pointing upward:

Charts courtesy of StockCharts.com

By and large, investors have had a volatile relationship with bank loans—and high-yield bonds—in recent months, due to the negative impact oil prices have had on credit markets. But the appeal of bank loans centers on the fact that they are higher in the corporate structure, and they are floating-rate securities.

That means their coupons adjust with changes in interest rates—something that offers income without much duration risk at a time when the market is concerned about duration exposure in a rising-rate environment.

‘Outlook Constructive’

Guggenheim’s analyst team, led by Global Chief Investment Officer Scott Minerd, said this week the “fundamental outlook for leveraged credit remains constructive.”

“Spreads exceeded 900 basis points in February 2016, levels that are consistent with implied six-month forward default rates in the 9-10% range,” Guggenheim said in a research note this month. “We believe this default risk is overestimated in the current environment.”

Beyond default risk, the Federal Reserve’s decision to keep rates low for longer should also benefit bank loans as borrowing costs remain low, Guggenheim says.

“As 10-year U.S. Treasury yields decline further, loss-adjusted yields in bank loans look especially attractive, even when stressed for the level of credit losses experienced during the financial crisis,” the company said.

BKLN currently has a 30-day yield of 6.25%—a yield that has risen about ¾ of a percentage point from levels seen just last October, when 30-day yield was around 5.5%.

The fund tracks an index comprising the 100 largest bank loan facilities—floating-rate, high-yield senior debt issued by banks to companies—and has nearly $4 billion in assets under management.

SRLN, which is actively managed, and invests in noninvestment-grade, floating-rate senior secured debt, had a 30-day yield of 3.6% as of April 13. The fund, which is now three years old, has gathered more than $765 million in assets.

The Risks Of Liquidity

If fundamentals look positive for the segment, liquidity remains a concern.

“Bank loans are not technically ‘securities’ the way other capital assets are; have nonstandardized settlements; and are much more of an over-the-counter-type trading structure, which means they’re more manual and tedious to trade, and that affects price discovery,” Will McGough, portfolio manager and senior vice president at Stadion Money Management, recently told ETF.com

ETFs have a done a great job at trading tighter than the underlying markets for bank loans, “but if a period of stress comes along, with the advent of bank loan ETFs, we might see extra undue stress, as they are a more opaque market relative to high yields,” McGough said.

Also impacting liquidity is the fact that a lot of these loans are owned by a small number of funds, according to UBS.

Bloomberg reported that “more than 50 percent of high-yield bonds and 35 percent of leveraged loans are held by funds with significant redemption risk.” Citing a note written to clients by UBS strategists, the article said that loans could “suffer more in a downturn than in previous crises because they’ve become concentrated in funds that allow early redemptions.”

“The market is in less steady hands,” the note said, according to Bloomberg. “The amount of corporate credit owned by fund structures that are highly susceptible to a ‘first mover’ redemption risk has ballooned since 2009.”

Contact Cinthia Murphy at [email protected].