Beware of Loan Overvaluation Is Message From Top ETF

It’s getting more expensive for investors to get their money out of leveraged loans, based on that market’s biggest exchange-traded fund.

As demand for the high-risk, high-yield loans dries up, ETF investors have been accepting prices that are below the market average to cash out of the $6 billion PowerShares Senior Loan Portfolio. The fund, which is overseen by Invesco Ltd., has declined 1.7 percent since the end of June, compared with a 0.9 percent drop on its benchmark index.

The dislocation suggests loans themselves would be priced at a lower value if they were bought and sold more frequently. The ETF shares trade daily like stocks on exchanges and thus often show more immediate prices moves than the debt they own.

“Fixed-income ETFs are oftentimes a better reflection of where the underlying pricing might be headed,” said John Hoffman, Invesco PowerShares’ global head of ETF capital markets. “It’s trading in more real time than the underlying components.”

The pricing also indicates investors are paying up to get out of this illiquid asset class. That charge to exit may soar in a deteriorating market.

“There’s been more sell pressure rather than buy pressure,” Hoffman said. “There’s a conversion price” to turning the loans underpinning the shares into cash.

Souring Sentiment

The loan ETF’s shares have traded at an average discount relative to the Standard & Poor’s Leveraged Loan 100 Index for the past year. The fund’s price fell to 0.4 percent below its net asset value as of yesterday, according to data compiled by Bloomberg.

The fund has traded below the market value of its assets for the longest period in its history, and at the second-steepest average discount among U.S. corporate-debt ETFs that are bigger than $1 billion during the last 12 months, Bloomberg data show.

The ETF, which was created in 2011, was a cash magnet last year, receiving about $5 billion of inflows, Bloomberg data show. Investors were drawn to the floating-rate nature of loans, largely on expectations yields would rise as the Federal Reserve curtailed its stimulus. They also were drawn to the speculative-grade debt’s relatively high yields as central bankers suppressed borrowing costs.

Sentiment has soured this year as yields unexpectedly plunged and policy makers warned the loan market looked frothy. Investors pulled $1.1 billion from the ETF during the eight months through November, Bloomberg data show. The fund has returned 0.2 percent in 2014, below the 1.5 percent gain for the S&P Leveraged Loan index.

“The ETFs have actually become more liquid than the underlying thing people are investing in,” said Dave Nadig, chief investment officer of ETF.com, a research and analytics firm. “That’s where price discovery is happening.”

This fund suggests the loan market has more to fall.

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