"You’ve got to know when to hold ‘em, know when to fold ‘em, know when to walk away and know when to run."
- Kenny Rogers, The Gambler
You know financial trouble is brewing when Seeking Alpha contributors start quoting The Gambler, but the great Kenny Rogers has a lot of the wisdom that today’s world of “do-it-yourself” investors, and especially ETF investors, need to hear. We love ETFs and there’s always that moment when the perfect fund matches up with the perfect trade and synergy (strong performance, billions of dollars in new assets) is born, but every hot streak comes to an end and like the song says, you have to know when to walk away. And for bank loan investors, it’s time to start taking those chips off the table.
So why the concern over bank loan funds? Is it because their heck of a hot streak, absolutely crushing their competitors, has come to a sudden and tragic end? Or the billions in new assets they’ve acquired during that run-up? The answer to the first is a solid no, the second is a maybe. Lots of asset classes out/underperform for long periods of time and bank loan ETF assets as a % of total loans is still relatively small, roughly 1%. The real problem with bank loan funds is that they have only one purpose, which is increasingly irrelevant as the market continues to cool off.
Specialization has been the dominant trend in ETF development over the last several years, easy to understand in a highly competitive industry dominated by a few big players who can charge next to nothing. Bank loan funds, also called leveraged loan funds, are easy to spot given they typically include the words “bank loan, floating, or senior loan” in their name, although there are some big differences within the space.
What they have in common is they are a collection of floating rate notes from corporate borrowers, typically below investment grade, and tied to a specific reference rate like LIBOR, plus a certain amount, for example 300 bps which gives you the “floating” rate which resets periodically. That reset is the prime attraction of a bank loan fund, as it means they have very low duration and thus very low interest rate risk when in a rising rate environment.
We classify the funds into three broad categories; investment grade, loans and Treasury, and there are substantial differences between them. Those in the investment grade space typically focus on loans from mega banks or captive corporate financing arms which gives them a higher average credit quality and somewhat lower effective maturity given a stated purpose of capital preservation. Next are the more well-known funds in the “loan” space which represent what most people think of as a bank loan fund, longer maturities and higher risk represented by lower credit quality. These funds were the true late cycle winners, strongly outperforming their more conservative peers during the period of rising rates. How well did they perform?
Both short- and long-term rates began to rise steadily in the third quarter of 2016, and not surprisingly, bank loans began to outperform their more “durationally” challenged peers, whether short or long term, corporate or Treasury. Compare the performance of our bank loan funds from the third quarter of 2016 to the end of the October of 2018 with that of some of the more common funds, including a suite of Treasury bonds funds, a short-term bond fund and the ubiquitous iShares Core Total U.S. Bond Market ETF (AGG).
Right Product, Wrong Trade:
There’s no denying that bank loan funds can have a role in your portfolio, but it must be a very specific one because they were intended to have a very specific purpose, to neutralize interest rate risk. In a rising rate environment typical of a late-cycle recovery, bank loan funds can deliver positive returns while shielding your portfolio from rising rates. But where are we in the cycle now?
It’s never apparent until after the fact, but the continuing downward shift of the yield curve and the relative lack of any further, sustained increases in 2018 would indicate that the economy is very much cooling and precisely when you’d want to have interest rate risk of a Treasury nature. Hence, the reason why floating rate funds have begun to underperform their duration laden peers and especially those whose duration comes from government bonds, where you’d absolutely want your duration coming from in the event of a serious correction.
Now the economy is not the market and could continue to deliver solid growth, but just the fact that Fed Chairman Powell and the rest of the FOMC are trying to talk down future rate hikes would seem to indicate that the probability of another series of 3-4 hikes in 2019 is unlikely. In fact, Chairman Powell even said we’re approaching the neutral rate, a balance point between having too much liquidity and not enough, making the possibility of a prolonged pause more likely.
What you don’t know can absolutely hurt you:
But “cycle” risk is just one of the more obvious problems with bank loan funds, the bigger ones go to their basic nature. To quote Shakespeare, “the fault, dear Brutus, is not in our stars, but in ourselves.”
Most investors would treat bank loan funds, and ETFs in general, as one-trick ponies, and in a certain sense, they’d be right. All bank loan funds were designed to eliminate interest rate risk, but in almost any other market environment they’d be unattractive, but in a recession, they could be almost deadly.
We’ve already mentioned that the bank loan market isn’t exactly overflowing with strong, reliable borrowers, but you’d be amazed just how bad it can be. Bank loans are also called leveraged loans, and with good reason, they’re typically made to firms with less than stellar credit risk who wouldn’t be able to borrow in the fixed credit markets. Think about it, would you rather be able to borrow at a fixed rate (which you could then hedge against) or at a variable rate like LIBOR + x bps, especially in the later stages of a credit cycle where 3-month LIBOR has already risen substantially, almost doubling in the last year?
Most bank loan ETFs pull their investments from the more credit worthy side of the market, with the iShares Floating Rate Bond ETF (FLOT) having an average credit quality of “A” while the Invesco Senior Loan ETF (BKLN) is all the way down at “BB” with almost a third in single B names and perhaps one reason why it’s down almost 4x as much as FLOT in the last month. But even if the names are more credit worthy, where we are in the business cycle, close to the end of a cycle where ample liquidity and credit expansion has been a major theme absolutely matters and a substantial portion of bank loan issuance goes to repaying earlier loans, making a loss of liquidity deadly.
In fact, a recent blurb by Moody’s (Lower recovery rates to haunt U.S. leveraged loans) put more than 64% of outstanding loans at B2 (way below investment grade) or lower with 43% of new issuance in 2018 in their B3 or highly speculative category. Add to the fact that while they typically have senior status in the event of default, the bulk of new issuance is covenant-lite, meaning there are almost no restrictions against taking on more debt, using the proceeds to pay yourself huge dividends, etc. How deadly is a matter of debate, leveraged loan default rates are hard to estimate, but during the prolonged agony of the dot.com fallout, Moody’s data showed that annual default rates of anywhere from 7%-8% with recovery of principal dropping to below 40%.
Like any good gambler, investors today need to know all the strengths and weaknesses of their cards and bank loan funds can make for a powerful hand but only in the right situation, and with a weakening outlook, now’s the time to be thinking about folding.
Disclaimer: Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. ETF Global LLC (“ETFG”) and its affiliates and any third-party providers, as well as their directors, officers, shareholders, employees or agents (collectively ETFG Parties) do not guarantee the accuracy, completeness, adequacy or timeliness of any information, including ratings and rankings and are not responsible for errors and omissions or for the results obtained from the use of such information and ETFG Parties shall have no liability for any errors, omissions, or interruptions therein, regardless of the cause, or for the results obtained from the use of such information. ETFG PARTIES DISCLAIM ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO ANY WARRANTIES OF MERCHANTABILITY, SUITABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE. In no event shall ETFG Parties be liable to any party for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, or losses (including, without limitation, lost income or lost profits and opportunity costs) in connection with any use of the information contained in this document even if advised of the possibility of such damages.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.