Bank Loan ETFs: How to Handle a Crunch

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Bank loans are all the rage in exchange-traded funds. But easy-to-trade ETFs can't cure an illiquid market of its illiquidity. What happens if too many investors try to crowd out the door at once?

Answer: ETFs in such cases reflect negative investor sentiment to a tee. They trade to steep discounts versus net assets, adding insult to injury if you're the investor with the poorly timed trade. It happened to a range of bond exchange-traded funds during 2013's interest-rate scare, and it'll happen again.


"What happens if outflows continue? Who are you going to sell the loans to? It could disrupt that market," said Dan Fuss, vice chairman and a veteran bond-fund manager at Loomis Sayles & Co., which oversaw $209.9 billion in total assets as of the end of March.

This isn't a new message. Here's what two key fund executives said in October at the Morningstar ETF Invest conference, as reported by this blog back then:

Ken Volpert of Vanguard Group's fixed-income group has a warning for investors who've grown enamored of senior loan funds: Be careful.
"Bank loans are basically floating rate high yield investments," and they "definitely have some liquidity issues," Volpert told conference goers at Morningstar ETF Invest in Chicago on Thursday. "The thing to keep aware [of], if there is a recession, don't think of this floating rate loan portfolio as … 'It's going to hover around par with a three or four percent yield.' You could lose a large percentage of the portfolio.
The Vanguard executive also added a word of explanation why his company doesn't have a rival to PowerShares Senior Loan Portfolio (BKLN) or the other swiftly rising bank- and senior-loan ETFs: The fear of overcrowding a small and currently very trendy market.
"How big is the outstanding in that market? It could become very big," if funds keep growing at the current pace — which panel moderator Tim Strauts said was a doubling of investor assets in the last year.
"Are we ultimately creating a tool that could create a lot of flows into too small of a market that leads to a bubble? We are conscious of that. We don't want to come out with something faddish … The market is small and it could get overcrowded, and ultimately lead to something that creates a problem for investors."
BlackRock's Steve Laipply, speaking on the same panel added: "Bank loans are not CUSIP securities. They're physical loans … In a recession, or if you have a market event or 'risk off' event, the liquidity profile of loans probably means they'll be more volatile than they currently are.
"You'll notice that [the ETFs] do hold high yield bonds," Laipply continued. "Part of the reason they hold them [is] they're using them as a liquidity buffer in case they need to meet redemptions. You'll probably see more volatility with a loan fund.
"It doesn't show up right now [because the market is] sanguine," Laipply concluded. "But if you do go back, [you'll see] the S&P 100 loan index behaved during the fall of 2008 with a pretty significant amount of volatility."

So what should investors do? Not much if you've kept your allocation small. ETFs force investors to pay their own trading costs in the form of premiums and discounts, so be aware that selling in a panic could be costly. Realize that getting quick, easy access via ETFs to a tough-to-access market doesn't happen for free.

The PowerShares ETF is ahead by 1.6% for the year entering Tuesday's session, versus 3.8% for iShares iBoxx $ High Yield Corporate Bond Fund (HYG) and 4.2% for SPDR Barclays Capital High Yield Bond ETF (JNK).