Scott Burns: ETFs expand in the variable fixed income market.
Hi there, I'm Morningstar's director of ETF research, Scott Burns. Joining me today is analyst Tim Strauts.
So, Tim, we've had a new launch from the PowerShares group into the bank loan market. Before we talk about the fund specifically, let's talk a little bit about bank loans and how they differ from probably what investors are really used to when they look at fixed-income and fixed-income funds.
Timothy Strauts: Sure. The bank loan space, the first key difference we want to look at is the name, bank loans. It's not bank bonds; it's bank loans. So, these are not actually securities. They are actually loans. Originally in the '80s and '90s, they were given out by commercial banks and now the loans are given out by fund companies, but they are just loans.
Burns: Right. So, you are not lending money to the bank. These are loans that have been originated by the bank, have been securitized, and then are now out there. So, a General Motors would have a loan and a Procter & Gamble would have a loan, et cetera?
Strauts: That is all true, except for that they are not securitized.
Burns: They are not securitized...
Strauts: That's the one key thing. The other thing that's interesting about them is that they have floating rates. The interest rates on these loans adjust every 30 to 90 days based on a benchmark rate, which is usually the LIBOR rate--the London Interbank Rate.
Burns: So the LIBOR rate, which is probably unfamiliar to a lot of investors, that's very common parlance in the corporate banking space. It floats, it's the money that banks charge each other to lend money back and forth, so it is a floating rate, but it is different than, say prime, correct?
Strauts: Yes, it is different and will adjust differently. So these rates are all LIBOR plus something, LIBOR plus 2, LIBOR plus 3.
Burns: Right. So, why would an investor want a floating rate security, a floating interest rate? I think people are really used to, I have my coupon, I clip it, and that's the fixed rate. But this, the coupon rate on a month-to-month basis, it could be 5%, it could be 3%; it's going to move with that interest rate and the spread is what will maintain, right?Read Full Transcript
Strauts: I'll say that most investors generally don't like floating rate instruments except when they are expecting rates to rise. So, when rates are stable or rates are falling, no one wants a floating rate. But when people are expecting rising rates, then everyone rushes into the space, which is actually what we have seen. The Morningstar bank loan category has seen over $10 billion of inflows just in the first two months of this year, which to put that in perspective--just last year, it was $16 billion for the entire year, and that was a record.
Strauts: So, we are seeing massive investor interest.
Burns: There is definitely ... a lot of concern about rising interest rates and this does seem one of those ways to kind of help protect your portfolio from it.
So, switching from about bank loans, let's talk about this fund in particular. So, it's the PowerShares'…
Strauts: Senior Loan Portfolio.
Burns: And the ticker is…
Burns: Bank loan, very good and very crafty there.
So, let's get into the nuts and bolts of this fund. So, first and foremost, fee, how has it been trading so far? What are we looking at from a nuts and bolts perspective?
Strauts: Well, the expense ratio is 0.83%. It's been a very successful launch. It has over $70 million assets and it's only been out a few weeks. Trading volumes have been brisk. On its first day, it traded over 1 million shares. Now, that has dropped off in the following weeks, but clearly, money is flowing into the fund at a pretty good rate.
Burns: At 0.83%, for a general passive fixed-income fund, that is on the higher end when we look at fees. What do we think about the appropriateness of that fee? What's some of the reason for that?
Strauts: I think it's reasonable considering the space it's in, because again, these are bank loans, they are not securitized. The trading is a little more difficult. Just comparison-wise, mutual fund fees are much higher in this space. So, being less than 1% is good; obviously, we'd like it lower, but we can understand why the fee is higher.
Burns: So, from a ETF relative standpoint, it's on the higher end, but from a bank loan and other investible options…
Strauts: Definitely on the low end.
Burns: It's on the low end, okay, that's great.
So, I think one of the things when we think about this bank loan ETF is really getting into the particulars of the holdings and how those holdings and maybe some of the factors around liquidity and availability are going to affect this portfolio and its performance?
Strauts: So, one thing to know about bank loans, again because they are not securitized, liquidity can be an issue, and many of the mutual funds in this space for many years didn't actually have daily redemptions. They actually had tender offers, monthly or quarterly tender offers. So, if you bought the fund, you couldn't actually get out until the end of the month or the end of the quarter because of liquidity concerns.
Now that has stopped. All the mutual funds are daily liquidity now. But still, in a volatile environment, you could have some liquidity concerns.
So for an ETF, that's a concern because it's an exchange vehicle; it's traded every day. So what the fund is doing is two things: One, it can take a loan out for 33% of the fund's assets to meet investor redemptions.
Burns: So it can margin up. That's actually what we see more in the closed-end fund space. That's interesting.
Strauts: So it can actually margin up. Now, it says specifically in the prospectus, that they won't do it unless for emergency cash needs. What they also can do is ... 20% of the fund can buy closed-end funds, which is not actually part of the index tracking. And the reason to buy closed-end funds is closed-end funds trade on the exchange, and they are marketable securities, and you can sell them at any time. So if they needed cash in a pinch, they could sell their closed-end funds.
Burns: One thing just personally when I hear that--although the loan is available in concept, I mean, I think the issue you get when there is a liquidity run in bank loans is that it's generally because banks aren't lending or buying these securities, and so that I have a loan from a bank to back up the bank loans that other people want to buy, I'd be a little leery of that, but I don't think it's insurmountable. I think I am much more comfortable with the closed-end funds, although that is going to add cost to the fund because you are going to have to pay the closed-end fund fee.
Strauts: Sure. So one concern with the ETF owning closed-end funds is that it's bond closed-end funds today, which are trading at right around par to a slight premium. In a liquidity crisis, you would expect that the closed-end funds will start trading at discounts. So the ETF may be selling its closed-end funds at a discount, and therefore for investors in the ETF, you've just kind of taken that loss.
Burns: So I just think it is important for investors to know that it's not necessarily about the ETF itself. Bank loans are less liquid and are going to be suspect to liquidity issues. Owning the ETF is probably more liquid than owning an individual bank loan, presuming you could even get access to it. But to just be aware of that, that the ETF is not a magic solution around the underlying illiquidity, necessarily, of bank loans.
Strauts: The ETF will probably actually be more liquid than the other vehicles in the space, but never as liquid as a 10-year Treasury bond.
Burns: True, true. So, for folks looking for variable rates, what are some of the other options out there? You know this is only the bank loan ETF out there, but there are some other things investors could take a look at?
Strauts: So, this is the only thing that you're going to do that's a variable rate that in the bond space. Eaton Vance is filing for also a bank loan ETF, which may come out, who knows when. But they are going to come out.
Also the other thing to note with bank loans is that they are high-yield bonds. So there is credit risk you're taking here, because if a corporation is going to take a floating rate, there is obviously a reason they couldn't get a fixed rate. So they are high-yield bonds, but they are fully collateralized loans, so you are the first, in a bankruptcy, you are the first lien-holder.
So a lot of people also look to high-yield bonds, because in a rising interest rate environment, in general high yield bonds with their higher coupon insulates them from interest rate rises.
Burns: Well, Tim, even though it sounds like this is a more complicated ETF out there, it definitely sounds like given where we are in the interest rate environment and some of the fears, this is a valuable tool for investors' portfolios, would you agree?
Strauts: I would agree.
Burns: Well, Tim, thanks for joining me--a lot of great information. I'm Scott Burns with Morningstar. For this and other ETF information, please check out Morningstar.com's ETF Center and Morningstar's ETFInvestor newsletter.