Leverage Addicts Get Junk-Loan Fix With Derivatives ETF

Forget complicated total-return swaps and collateralized loan obligations. A proposed exchange-traded fund will make it much easier for anyone to use borrowed money to double down on junk-rated loans.

The AdvisorShares Pacific Asset Enhanced Floating Rate ETF will use derivatives to boost gains on high-yield loans, allowing retirees and pensioners to magnify bets on debt that promises higher yields when interest rates rise, according to a U.S. regulatory filing. The fund, which would be actively managed, is currently pending approval from the U.S. Securities and Exchange Commission.

Why use leverage now? Because for buyers who have faith the riskiest companies will pay back their obligations, the loans just aren’t quite yielding enough. With a little more risk, the thinking goes, the return will be sweeter.

Of course, any losses will also be more painful.

The proposed ETF comes at an interesting time, as investors split over whether they love or hate the below investment-grade debt. Federal Reserve regulators are warning that underwriting standards have deteriorated too much in this market, and mutual-fund investors have yanked cash from the debt for six straight weeks, according to Wells Fargo & Co. research.

That hasn’t stopped the biggest buyers from using more leverage through total return swaps and buying the lowest-rated portions of CLOs, which pool the loans and slice them into different tiers of varying risk and return, Barclays Plc (BARC) strategists wrote in a May 16 report.

Illiquid Market

The problem is, if fans of junk loans are wrong, their juiced investments won’t just increase the threat to profits, they’ll also have a magnified effect on the $1.1 trillion market that is one of the most difficult to trade in. Buying and selling takes place in telephone conversations and over e-mails, with sellers routinely waiting three weeks to settle a transaction, as opposed to just days for high-yield bonds.

About 33 percent of high-yield credit investors surveyed by Bank of America Corp. said they’re not holding junk-rated loans, while more than 33 percent said they had more than 15 percent of their assets in the debt, according to a May 19 report.

Some institutions are piling in at an accelerating pace, with Onex Corp.’s credit investment group raising a $1 billion CLO this month, the biggest in the U.S. this year.

So far, betting on high-yield loans hasn’t been a disaster, with the debt returning 1.7 percent this year, according to data compiled by Standard & Poor’s and the Loan Syndications and Trading Association.

While that’s less than half the 4.4 percent return on junk bonds, at least it’s up for now.

To contact the reporter on this story: Lisa Abramowicz in New York at labramowicz@bloomberg.net

To contact the editors responsible for this story: Shannon D. Harrington at sharrington6@bloomberg.net Caroline Salas Gage

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