ETFs Spur Loan Volatility as Funds Attract Cash: Credit MarketsSridhar Natarajan and Lisa Abramowicz
Leveraged loans are becoming more volatile as they attract unprecedented cash from investors seeking debt that offers protection from rising interest rates.
Loan prices have swung 11.92 cents on the dollar since the end of 2010, compared with a 1.5-cent fluctuation in the three years ended Dec. 31, 2006, according to the Standard & Poor’s/LSTA Leveraged Loan 100 index. Mutual and exchange-traded funds that focus on the floating-rate debt have attracted about $45.5 billion of new money this year, increasing their assets by 60 percent, according to Bank of America Corp.
While the flows have helped speculative-grade companies refinance and lower rates on more than $300 billion of existing loans, concern is rising that the cash could flow out just as quickly, causing borrowing costs to soar. Mutual funds and ETFs now own about 20 percent of the U.S. leveraged-loan market, about the most ever, and may contribute to bigger price swings going forward, according to Fitch Ratings.
“I don’t think it’s all going to be smooth sailing,” Darin Schmalz, a director at Fitch in Chicago, said in a telephone interview. “Looking at loans over time, it was a pretty stable asset class. We found out this can be a volatile asset class.”
This year’s flows into leveraged-loan funds contrast with $9.3 billion of withdrawals from U.S. high-yield bond funds, JPMorgan Chase & Co. data show, with investors fleeing debt that’s grown more vulnerable to rising rates after a four-year rally pushed yields to record lows. Yields on 10-year Treasuries climbed to 2.83 percent Aug. 16, the highest since July 2011 as the Federal Reserve considers slowing its unprecedented stimulus effort.
Trading has increased more than 12 times this year in the biggest leveraged-loan ETF, Invesco Ltd.’s PowerShares Senior Loan Fund, as investors seek a quick and easy way into a less-liquid, over-the-counter market, according to data compiled by Bloomberg.
Volumes in the underlying debt aren’t rising as quickly, increasing 53 percent in the past year, according to the Loan Syndication and Trading Association.
ETFs “might be a small part of the market, but they can have an outsized impact on market prices relative to their size,” Eric Gross, a credit strategist at Barclays Plc in New York, said in a telephone interview. “Investors and traders need to be cognizant of what the ETFs are doing because they can affect pricing, sentiment, and flows.”
Elsewhere in credit markets, the cost to protect against losses on corporate bonds in the U.S. rose with the Markit CDX North American Investment Grade Index, a credit-default swaps benchmark that investors use to hedge against losses or to speculate on creditworthiness, rising 1.3 basis points to a mid-price of 82.8 basis points at 11:55 a.m. in New York, according to prices compiled by Bloomberg.
In London the Markit iTraxx Europe Index of credit-default swaps tied to the debt of 125 companies with investment-grade ratings rose 0.23 to 99.05.
The indexes typically rise as investor confidence deteriorates and fall as it improves. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a swap protecting $10 million of debt.
The two-year U.S. swap spread was unchanged at 18.9 basis points. The gauge widens when investors seek the perceived safety of government securities and narrows when they favor assets such as corporate bonds.
Bonds of Charlotte, North Carolina-based Bank of America were the most actively traded dollar-denominated corporate securities by dealers last week, accounting for 3.52 percent of the volume of dealer trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
Investors have gravitated toward leveraged loans as they seek protection from losses incurred by rising rates while also getting extra income from lower-rated securities. Yields on 10-year Treasuries rose by more than a percentage point since December as Fed Chairman Ben S. Bernanke indicated policy makers could scale back monthly bond purchases this year.
Loans are typically pegged to floating-rate benchmarks that rise alongside increasing benchmark borrowing rates.
“It’s easy to raise money by offering such a simple solution,” Gary Herbert, a fund manager at Brandywine Global Investment Management LLC, which oversees about $38 billion in fixed-income assets, said in a telephone interview. “Smaller companies that are aggressively levered dominate the loan market. There’s a lot of misunderstanding about what happens when the central bank’s balance sheet shrinks.”
Loan mutual funds now manage more than $115 billion in assets, up from $71 billion in 2012, JPMorgan said in an Aug. 8 research note. Two new leveraged-loan ETFs started trading this year, including the SPDR Blackstone/ GSO Senior Loan ETF, a joint venture between Blackstone Group LP and State Street Corp. The fund started with $65 million in assets and has multiplied more than seven times in the last four months to about $475 million.
Invesco’s PowerShares Senior Loan fund, the first and biggest loan ETF, has grown to about $5 billion in assets since its inception in March 2011. The $5.5 billion in assets under management for loan ETFs at the end of July accounts for about 1 percent of borrowings included in the S&P/LSTA index, according to an Aug. 12 report from CreditSights Inc.
Trading volumes in Invesco’s ETF rose to an average 3 million shares per day in July, from about 241,000 a year earlier, Bloomberg data show.
“The market is still being driven by CLOs, but the relative importance of mutual funds has grown, and ETFs are kind of a tail on that dog at this point,” Alex Jackson, the head of the bank loan group in Armonk, New York at Cutwater Asset Management, said in a telephone interview. “The price volatility of the loan market is almost double what it was pre-crisis.”
The average price on the 100 largest first-lien loans climbed to a six-year high of 98.88 cents in May from 96.1 cents at the end of December, according to the S&P/LSTA U.S. Leveraged Loan 100 index. Accelerating demand for floating-rate debt has enabled speculative-grade borrowers to refinance $157 billion of loans this year, while reducing the rate on $187.7 billion of existing loans through the end of July, according to S&P’s Capital IQ Leveraged Commentary and Data.
This year’s rally has reversed the eight-month stretch through October 2011, when loan prices fell 9.5 cents as concern grew that policy makers would be unable to reign in spiraling borrowing costs in Europe that hampered Ireland and Portugal’s ability to sell debt. Spain, Greece, Ireland, Portugal and Cyprus all required bailouts, with policy makers creating the European Financial Stability Facility in 2010.
During the financial crisis, in the fourth quarter of 2008, bank loans underperformed speculative-grade notes, losing 23 percent.
“The interesting thing to note though is how the loan market has evolved post-crisis,” Fitch’s Schmalz said. The growth in the proportion of the market owned by individual buyers “will have an impact if investors begin to take money out of the asset class, which will force retail funds and ETFs to sell,” Schmalz said.
While collateralized loan obligations are still the dominant owners of the $593 billion U.S. leveraged loan market, holding about 53 percent of the debt, their share has dropped from 60 percent in the first quarter, according to the LSTA.
The volume of loans traded in the secondary market jumped to $150 billion in the three months through June, compared with $98 billion in the same period last year, LSTA data show.
The floating-rate debt has gained 3.1 percent this year, according the S&P/LSTA Leveraged Loan Index, outpacing the 2.3 percent gains on the Bloomberg USD High Yield Corporate Bond Index.
“There’s been a blindness toward the concept of risk while choosing duration protection,” Herbert said. “When the market sentiment turns, the less sophisticated investors will be the ones harmed.”