Demand for exchange traded funds investing in senior loans has rocketed this year as investors hunt for respite from rising inflation.
A net $7.3bn has been pumped into the sector so far this year, according to CFRA Research, almost doubling its asset base to $16bn.
The trend is linked to rising inflation and interest rate expectations in the US and elsewhere, leading investors to favour floating-rate loans over fixed-rate bonds.
“It’s a long-term pattern,” said Ben Johnson, director of global ETF research at Morningstar. “It’s almost a barometer of investors’ expectations with respect to the future direction of interest rates. When people are concerned about the possibility of increases we see inflows.”
“Demand for senior loan ETFs has skyrocketed in 2021 as investors have become more comfortable investing in fixed income ETFs,” added Todd Rosenbluth, head of ETF and mutual fund research at CFRA. “They are less interest rate sensitive than traditional credit.”
Senior loan ETFs invest in speculative grade securities, as do high-yield funds, which have seen outflows of late but offer higher returns to yield-starved investors. However, the funds hold securities that are more senior in the capital structure, and exhibit lower volatility.
Although senior loan ETFs represented just 0.6 per cent of global fixed-income assets at the start of the year, they accounted for 6.5 per cent of net inflows during 2021, based on figures from CFRA and ETFGI, a consultancy.
The figures mark a sharp reversal in fortunes. Bill Ahmuty, a head of fixed income group at State Street Global Advisors, said senior loan mutual funds and ETFs suffered net outflows of about $65bn between late 2018 and the end of 2020.
“In August/September last year people’s view on rates started to change. We started to see long-term rates pick up. That was when we pivoted and we started to see a return back into the asset class,” he said.
“They are looking to reduce the duration of their portfolio so they migrate to floating rate products.”
Net inflows across senior loan mutual funds and ETFs have hit $20bn so far this year, Ahmuty said, with ETFs accounting for a disproportionately large share, a fact he attributed to the fund structure’s solid performance during last year’s Covid-driven spike in volatility.
The SPDR Blackstone Senior Loan ETF (SRLN), the second-largest ETF in this category, has seen its assets triple to $6.5bn so far this year. Pension funds, wealth advisers, insurance companies and even loan managers have bought in, using the fund to gain rapid exposure to the asset class.
According to SPDR, loans have historically witnessed volatility of 5.8 per cent a year, compared to 7.7 per cent for high-yield bonds. Average yields are typically a little lower for senior loans, at 3.7 per cent versus 4.2 per cent for high-yield bonds.
However, they tend to invest in less liquid securities and tend to charge higher fees. The $6.7bn Invesco Senior Loan ETF (BKLN), the largest fund in the sector, had an expense ratio of 0.67 per cent and Blackstone’s SRLN of 0.7 per cent.
A high proportion of senior loan ETFs are actively managed, including SRLN, the First Trust Senior Loan ETF (FTSL) and the Franklin Liberty Senior Loan ETF (FLBL). Some 57 per cent of senior loan ETF assets are active, Rosenbluth said, an unusually large figure given that 90 per cent of the wider fixed income ETF market and 96 per cent of overall ETF assets are managed passively.
The illiquidity of loans “lends itself better to discretionary management than indexing,” adding “it’s not all that difficult for active managers to do better than the benchmark”, Johnson said.
Rosenbluth said the active funds had a higher exposure to lower grade triple C and single B credits than passive ETFs, helping them outperform by about 1.5-2 percentage points so far this year.
“Active managers are taking on more credit risk within the senior loan space. The active managers are doing their own credit risk and default analysis,” he said.
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