Can Senior Loan Funds Withstand Rising Rates?

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Senior loans are an intriguing but illiquid asset class. Joining me to discuss this topic is Alex Bryan, he's director of passive strategies research for North America for Morningstar.

Alex, thank you so much for being here.

Alex Bryan: Thank you for having me.

Benz: Let's start with a really basic question. What is a senior loan?

Bryan: So a senior loan is also often called a bank loan or a leverage loan. These are basically loans that are made to corporate borrowers from either a private bank or a syndicate group of lenders. And they are typically made to borrowers that are below investment grade. These are typically lower-credit-quality borrowers and they are loans that allow those borrowers to obtain a lower interest rate than they might in the public bond markets. And typically these loans are secured by assets on the borrowers' balance sheet, which gives the lenders some security and in addition to that, one of the distinguishing characteristics of these loans is that they are floating-rate. So their interest rates are reset every quarter. So those are two of the main characteristics of the bonds.

Benz: So I know one big attraction with a lot of investors over the past several years off and on has been this idea of having a product type that is relatively impervious to interest-rate changes. Let's talk about why that works and why that has been an attraction recently.

Bryan: Sure. So obviously a lot of investors are worried about the potential for rates to start to tick up, and when that happens most fixed-rate bonds tend to decline in price--that's the relationship between rising rates and prices of bonds. Floating-rate debt or floating-rate instruments don't go down in price nearly as much when interest rates tick up. So most of these senior loans, they have interest rates that are reset every quarter. They are basically, the rates are indexed to Libor, which is a floating-rate interest-rate index. So every quarter the interest rates will fluctuate on these instruments. So when rates start to go up, these instruments start to pay more interest. So that way their prices don't go down by as much as a fixed-rate debt instrument.

Benz: You noted in a recent piece in Morningstar ETFInvestor that the default rates and the recovery rates on these loans are better than high-yield bonds'. I think sometimes investors kind of lump them together and think of them as similar in quality. But you say actually the default rates and the recovery rates are better. Let's talk about first what's the difference between those two things and why bank loans have enjoyed a little bit of an advantage from that standpoint.

Bryan: Sure. So default rates, that's the percentage of bonds that don't meet their schedule, their obligated interest payments or principal repayments. And typically for lower-credit-quality borrowers that tends to be higher than for investment-grade borrowers. Now if you compare senior loan borrowers to high-yield borrowers, they are in the same neighborhood in terms of their default rates. So for senior loan borrowers historically if you look between 1998 and 2015 the default rate was about 3.2%. For the high-yield bond market over that period it was about 4.6%. it was a little bit higher for high-yield bond borrowers. Not necessarily because those are lower-credit-quality borrowers than senior loan borrowers, but because it's more difficult for senior loan borrowers to experience a technical default. That's a default that’s triggered by a clause in the contract that's not directly related to repayment of the debt.

So it's been a little bit lower for senior loan borrowers in terms of their default rates. The biggest difference, though, has come on the recovery rate side. Now the recovery rate is the percentage of assets that you get back when a default takes place. So if I lent you $100, and you default on your debt, the recovery rate would be what percent of that $100 do I get back, ultimately through, whether it'd be asset sales of whatever the case maybe.

For senior loans historically their recovery rates have been about 80%. You contrast with high-yield bonds it's ranged anywhere between 20% to 40%. So it's considerably higher. So you put those two things together, slightly lower default rates, much higher recovery rates--the credit losses tend to be lot lower for senior loan debt.

Benz: OK. But the nonetheless this is a fairly risky type of fixed-income instrument. Well it's not a fixed-income instrument. But a fairly risky sort of bond type, so you'd want to make sure that you are not using it in lieu of kind of high-quality bond exposure.

Bryan: That’s absolutely right. So these loans are risky for two reasons. One, you are investing in lower-credit-quality borrowers. These are the types of borrowers that go to the junk market. So if the economy starts to sour, credit spreads start to widen. These types of instruments don't do quite as well. So that certainly is a risk. And it's equitylike in the sense that it's sensitive to the business cycle, just like high-yield bonds are.

The second risk, which maybe a little bit harder for people to get a handle on but it's a very important risk, is liquidity risk. These instruments are very illiquid. Meaning they don't trade very often. So if I am owning these instruments and I want to sell it to raise cash, it may take me a while to find someone to buy it, and once I do find someone to buy it I may have to take a haircut on the price that I may be able to get in order to make that transaction happen. So that's one risk.

The second risk is there really isn't a predefined settlement period for senior loans. When you go to trade a bond on the market, all those bonds have to settle on T+3 settlement. That means three days after I make the transaction I have to receive the cash from the counterparty. With the senior loan instruments there is no maximum period for settlement to occur. So it could take several weeks for me to get the cash that I need from my sale of that instrument. So that certainly is a risk that investors face.

Benz: So this liquidity risk, it sounds like it’s a big one in addition to the credit risk. Let's talk about to the extent that funds try to kind of manage for those risks and there are mutual funds that are set up to invest in senior loans. Let's talk about some of the strategies they use to make sure that they are not stuck in this liquidity crunch where they may be having redemptions. The manager has to sell stuff to meet those redemptions. What sorts of guard rails do funds put up to try to kind of protect themselves?

Bryan: There's a few levers that you can pull to manage this liquidity risk. One, holding cash in the portfolio as a way to mitigate or be able to meet redemptions as they occur. That's probably the safest and easiest way to do it. So most managers will either hold a sleeve of their portfolio in cash or in very liquid securities, typically high-yield bonds which have T+3 settlement. The second option is to stick to the more liquid senior loans. The more liquid senior loans tend to settle more quickly than some of the others. And so that can help with some of these liquidity challenges. The third option is to request accelerated settlement from your counterparties or from the clearing house.

Now there is no legal obligation for a clearing house to offer or the counterparties to offer accelerated settlement. From the managers that I have talked with, they said that typically their counterparties are willing to acquiesce if they request accelerated settlement. That's not an uncommon practice. And it's been a way that lot of managers have been able to manage liquidity.

The final lever, and this is one that’s used as a lever of last resort, is to establish an emergency line of credit so that if you do enter a period where you need to raise cash right away, but you haven't received the cash from the sale of your securities, you can borrow to raise the cash that you need to meet those redemptions. But that should be used only as a last line of defense.

Benz: I remember we saw last summer there was a prominent open-end fund that actually turned to line of credit I believe to manage redemptions last summer. So, let's talk about ETFs because in a lot of ways this seems like an ultimate mismatch that you have what you say is a relatively illiquid asset class, these senior loans, married with an investment vehicle that gives investors, quite a lot of liquidity, intraday liquidity. So let's talk about sort of whether fundamentally there are challenges to marrying those two things together.

Bryan: Well there absolutely are. Because ETFs provide intraday liquidity whereas these underlying holdings, they can take up to several weeks to settle. So that's actually a key reason why BlackRock said that they would not offer a senior loan investment strategy in an ETF wrapper. Now that said, there are providers out there that do offer this strategy in an ETF wrapper. To manage those liquidity challenges, either the managers will stick to the more liquid senior loans or they'll pull each of these other levers that we talked about holding a portion of the portfolio in cash, in high-yield bonds that trade on T+3 settlement, or by establishing an emergency line of credit. So they all use these levers to manage liquidity, but it is certainly a risk that investors need to be mindful of. And ETF wrapper also constrains really constrains those managers to really focus on the more liquid senior loans in the market.

Benz: Another related question is index construction, if the ETF is tracking some index of senior loans, do you end up with the most profligate borrowers sort of at the top of the pile, the most heavily weighted companies. Are those necessarily the ones you want at the top of pile. So sort of index construction I think is another question.

Bryan: So there is actually two ETFs that are passive in that they track an index. Those are PowerShares Senior Loan ETF, ticker BKLN and Highland/iBoxx Box Senior Loan ETF, SNLN. Those each track an index which--the PowerShares fund basically tracks an index that targets the 100 largest senior loans, which as you mention are the more heavily indebted issuers. That's a critique that a lot of people have made of any type of market-cap-weighted bond index. But yes it's a necessary evil because if you are going to stick to the more liquid loans, those are going to be the loans that are more heavily traded that are larger in issuance. So yes you are going to get exposure to some of the more indebted issuers, but I think that’s a fair trade-off because that liquidity risk is a bigger one and I think an ETF wrapper a risk that's more concerning than some of those credit risks that we talked about earlier.

The Highland fund provides similar exposure specifically targeting the 100 most liquid senior loans, which there is a lot of overlap between the two indexes but they are slightly different in their focus.

Benz: For some of the reasons that we've talked about you actually think active management within the ETF space is perhaps a better way to go than some of the index products. Let's talk about a couple of the funds that you and the team look at and that you think are worthwhile.

Bryan: So some of the challenges that we talked about with the index space--anytime you are forced to manage liquidity, you have inherent tension between tracking your index and managing these redemptions. That can be a challenge. And active managers really have more flexibility to manage that liquidity risk that we talked about. So there is two ETFs that offer an actively managed approach to senior loans. Those are the SPDR Blackstone/GSO Senior Loan ETF, ticker is SRLN. And First Trust Senior Loan ETF, ticker FTSL. Of those two funds, they both do a lot of bottom-up credit analysis to try to identify mispriced securities or mispriced loans. And they do that really by doing a bottom-up credit analysis, identifying some of the things that the credit rating agencies may miss.

Of the two strategies I prefer the SPDR Blackstone/GSO Senior Loan ETF because GSO is actually one of the world's largest issuers of senior loans. This is a fund that's able to participate in the primary market. So they have a lot of experience in this space and I think being able to tap into the primary market gives them an additional opportunity to identify mispriced loans and that gives them a bit of an edge or a leg up over their peers. But I think being able to manage that liquidity risk is a huge part of why I prefer the actively managed strategies. They don’t charge all that much more than the index funds in the space.

Benz: So I wanted to ask about anytime you mention Blackstone I think that may be not the cheapest product around.

Bryan: The difference in fees is relatively small between these strategies. So I think that this--the extra fee is well worth the or the extra oversight on that liquidity management process is well worth the additional fees.

Benz: OK. Alex, important topic. Thank you so much for being here to provide your insights.

Bryan: Absolutely.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.