The US leveraged loan market surged past the $1 trillion mark earlier this year—an impressive feat for an asset class that counted just $500 billion in assets under management eight years ago.1 Leveraged loans, also referred to as senior loans as they are senior in the capital structure to traditional bonds, are growing in popularity as investors seek yield while keeping an eye on duration as interest rates rise. Given their seniority, there is also element of not stretching for yield, a notion supported by positive loan ETF flows in 2018 compared to a dearth of outflows in traditional high yield.
As senior loan demand surges, however, I'm fielding more investor questions about senior loans, senior loan ETFs and potential risks. These questions aren’t surprising. During the Federal Reserve's unprecedented “zero interest rate policy” era, yield-starved investors turned to different subsectors of the fixed income market, like unconstrained bond funds (UBFs), to access bond-like income with lower duration risk. However, not all investors understood UBFs’ potential risks—and that adding bonds further down the credit scale that are equity-like to a portfolio could result in increased volatility.
As with any investment, senior loans are not without risks. But understanding how senior loans and senior loan funds perform helps to highlight the role this asset class can play as a valuable complement to a core fixed income portfolio in today’s environment.
Tracking flows into senior loan funds
Senior loans are floating-rate debt issued by corporations and backed by collateral, and the current environment has been favorable for these loans. Senior loans enjoy seniority in the capital structure, helping to mitigate drawdowns during risk-off events compared with traditional fixed rate high yield. They also tend to exhibit lower equity correlation than fixed rate high yield and exhibit negative correlation to traditional bond segments, like Treasuries and corporate bonds, helping to improve overall portfolio diversification.2
Senior loans also have a floating rate coupon that resets every three months. This floating-rate structure has allowed senior loans to harness this year’s 38% rise in short-term interest rates.3 With the Federal Reserve on track to raise rates four times this year, investors are flocking to senior loan funds to help shorten duration while generating income.4 Given these attributes, senior loans ETFs have attracted $1 billion in flows year to date.5
Senior loans: Addressing investor worries
Let’s start by tackling concerns over volatility. This is a below investment grade asset class, so there is credit risk to be considered. The chart below, however, shows that senior loans, represented by the S&P/LSTA U.S. Leveraged Loan 100 Index, are less volatile than their fixed income counterparts, including high yield bonds and emerging market debt. In addition, they've exhibited less volatility than large-cap, small-cap and emerging market stocks. The chart also speaks to another senior loan attribute—asset protection. Senior loan drawdowns are far less dramatic than those of equities, or equity sensitive areas like convertibles, and nearly 3% less than traditional fixed rate high yield—a likely byproduct of the seniority in the capital structure.
During this year’s market sell-off, senior secured loan prices remained stable in contrast to high yield bonds, investment grade bonds and equities, underscoring their low-correlated nature. To date, loans are up over 2%, while fixed rate high yield is flat at 0.08% and broad investment grade corporate bonds are off 2.4%.6
Understanding the layers of senior loan ETF liquidity
Now let’s talk about the availability of liquidity.
In times of market stress, such as the February sell-off, ETF liquidity worries naturally flare up and articles are written decrying their very existence (yawn). During these events it's helpful to remember that ETFs offer two levels of liquidity—primary market liquidity and secondary market liquidity. Primary market activity refers to the creation and redemption of ETF shares. Trading on the secondary market entails buying and selling of existing ETF shares. Typically, only a fraction of secondary market transactions result in the creation or redemption of ETF shares. This second leg of liquidity lessens the number of trades that may lead a portfolio manager to sell underlying assets to fulfill redemptions.
The SPDR Blackstone / GSO Senior Loan ETF (SRLN) is an actively managed senior loan ETF. The chart below zeros in on the trading activity of SRLN during February’s sell-off. While SRLN's secondary market activity spiked during the correction, its primary market activity did not. The lack of primary market activity means underlying loan prices and liquidity were not impacted by the ETF's spike in trading activity, and investors were able to efficiently transfer risk between willing buyers and sellers.
Another way to put SRLN's impact on underlying senior loan prices in context is to study the fund's trading over a longer timeframe. From February through June, SRLN traded about $20 million on the secondary market, with an average daily primary market activity of $6 million. The resulting ratio of secondary market volume to primary market activity over that time frame is close to 4:1.7 For every $4 traded on the exchange, only $1 was created or redeemed. Again, this clearly illustrates that only a fraction of senior loan ETF trades touch the underlying asset classes, therefore, allowing investors to efficiently transfer risk, modulate exposure and tailor portfolios with precision.
Using active management to mitigate liquidity challenges
For investors worried about bank loan liquidity, an actively managed loan fund, like SRLN, can help mitigate liquidity challenges. SRLN’s active management allows it to focus on credit selection to avoid a weak or failing senior loan that might be included in a passive strategy, such as Toys“R”US.8
While underlying loans have an extended settlement cycle, SRLN's active managers can use their experience in trading and scale in the loan market to short settle if necessary to adequately meet redemptions. SRLN also holds roughly 7% in cash and 4% in high yield bonds to assist in managing daily liquidity.9
Senior loan ETFs have performed as expected during times of market stress, acting as a price discovery tool and allowing investors to make capital allocation decisions in real time, based on the shifting market environment. If there were a severe credit event that forced mass redemptions across the loan market as it did during the Financial Crisis, any loan strategy would face issues. But the ETF wrapper provides additive liquidity as a result of the secondary market.
For those who are still worried that ETFs will have an outsized influence on senior loan liquidity, it helps to look at senior loan ownership. As shown in the chart below, loan mutual funds and ETFs account for just 21% of senior loan ownership. Within that 21%, ETFs make up just 9%, meaning they are only 1.3% of the entire $1 trillion senior loan market.10 Given that ETFs in particular account for such a small percentage of senior loan ownership, it's highly unlikely these funds would be responsible for distorting underlying senior loan prices, or causing a run on the asset class.
Senior loans: Putting concerns to rest
When all is said and done, the data and examples above show that:
- Senior loans are less volatile than their fixed income peers, and equities!
- Senior loan ETFs have demonstrated ample liquidity during market sell-offs
- Senior loan ETFs have performed as expected in times of market stress
This performance data, combined with the fact that senior loans may help shorten duration while generating income in the credit sleeve of a portfolio, make them an asset class worthy of exploration. To learn more about senior loans you can read my blog, 4 Reasons to Consider Senior Loans in the Current Market.
1“The rise of leveraged loans as $1tn asset class,” ft.com, as of 5/3/2018
2Bloomberg Finance L.P., as of 6/30/2018, based on daily returns versus the S&P 500® Index, Bloomberg Barclays US Aggregate Index, and Bloomberg US High Yield Corporate Index from 6/2013 to 6/2018
3Bloomberg Finance L.P., as of 07/03/2018, based on the US 3 Month Libor
4"Fed hikes rates, points to two more increases by year's end," cnbc.com, as of 6/13/2018
5Bloomberg Finance L.P., as of 06/30/2018
6Bloomberg Finance L.P. as of 07/06/2018
7Bloomberg Finance L.P., as of 4/30/2018
8Bloomberg Finance L.P., as of 5/11/2018
9Bloomberg Finance L.P., as of 6/30/2018
10Morningstar as of 05/31/2018
Actively Managed ETF
An exchange-traded fund that has a manager or team making decisions on the underlying portfolio allocation or otherwise not following a passive investment strategy. An actively managed ETF will have a benchmark index, but managers may change sector allocations, market-time trades or deviate from the index as they see fit. This produces investment returns that will not perfectly mirror the underlying index.
The ability to quickly buy or sell an investment in the market without impacting its price. Trading volume is a primary determinant of liquidity.
S&P/LSTA U.S. Leveraged Loan 100 Index
A benchmark that is designed to reflect the largest loan facilities in the leveraged loan market. It mirrors the market-weighted performance of the largest institutional leveraged loans based upon market weightings, spreads, and interest payments. The index consists of 100 loan facilities drawn from a larger benchmark, the S&P/LSTA (Loan Syndications and Trading Association) Leveraged Loan Index (LLI).
The tendency of a market index or security to jump around in price. In modern portfolio theory, securities with higher volatility are generally seen as riskier due to higher potential losses.