Why Bank Loan Funds Need Active Management in This Market
Illiquidity and credit risk make indexing less effective in the bank-loan sphere.
Higher yields, floating rates, and a higher position in firms’ capital structure form the chorus that sings the siren song of the bank-loan market. These are obligations typically issued by companies that have received a below-investment-grade rating, hence the higher yields. The coupon rate for these obligations float based on Libor, so investors are protected from interest-rate risk during periods of rising interest rates. And they offer greater protection than a traditional high-yield bond in the case of a default, so they do not typically suffer as much as high-yield bonds when credit spreads widen.
Over the 10 years through March 2020, the average 12-month yield for market-value-weighted index funds in the bank-loan Morningstar Category was 1.35 percentage points higher than that of similar funds in the corporate bond category. But there is no such thing as a free lunch. Risk and reward are highly correlated in the fixed-income market. For instance, this strategy fell by 20.72% between Feb. 19, 2020, and March 23, 2020, the peak to trough of the coronavirus financial crisis.
Invesco Senior Loan ETF (BKLN) provides market-value-weighted exposure to the senior loan market for a reasonable fee. But active management is the best route to navigate the illiquidity risk and credit risk inherit in this market. As a result, this fund earns a Morningstar Analyst Rating of Neutral.
This strategy tracks the S&P/LSTA US Leveraged Loan 100 Index, which includes the 100 largest senior loans and weights them by market value. Senior loans are private loans that are taken out by a company from a bank or syndication group of lenders. Firms that issue them are typically rated below investment-grade, so they contain a lot of credit risk. But unlike high-yield bonds, the loans in the index are secured against the assets on the issuer’s balance sheet, which tends to give them higher recovery rates. These loans can protect against rising rates because their coupon payments are floating. As of April 2020, the fund’s average effective duration was less than a fourth of a year, which is generally in line with the senior loan category average.
While senior loans may be suitable for some investors, they are very illiquid, so they aren’t well-suited for index investing. These private loans are not registered with the SEC and can be challenging to trade; they tend to trade infrequently, in small amounts, and often have large spreads. And it can take weeks for trades to settle. Consequently, the fund must hold positions in cash or liquid bonds to provide daily liquidity.
The strategy attempts to mitigate the issues of indexing in this market by tracking an index that limits its exposure to the 100 largest senior loans. While this helps reduce some of the liquidity challenges, it doesn’t completely solve them. And this keeps the fund from delving into smaller loans available to actively managed funds, which may offer higher returns. Active management is probably a better way to go in this market, in light of its credit and liquidity risks.
People: Invesco’s senior loan team is one of the largest in the industry, with experienced managers and low turnover. This includes several members of the team that runs the actively managed Invesco Floating Rate strategy. While Invesco’s senior loan team is well-equipped to run senior loan portfolios, it doesn’t specialize in index management, and tracking error has remained stubbornly high. Accordingly, the team earns an Average People Pillar rating.
This strategy is managed by Scott Baskind and Seth Misshula, chief investment officer and head trader for Invesco’s Senior Loan group, respectively, as well as Peter Hubbard, Jeffrey Kernagis, Gary Jones, Philip Fang, and Richard Ose, who are fixed-income portfolio managers for Invesco. Baskind, Hubbard, Kernagis, and Fang have been named portfolio managers since the fund’s inception, while Jones was added in 2012, and Misshula and Ose were added in 2014.
The team has made strides toward improving the automation of its processes. The team incorporate BlackRock’s Aladdin portfolio management system, widely regarded as an industry-leading technology, five years ago. There has been a gradual migration of modeling work previously done in Excel to Aladdin, enabling a more streamlined approach.
Process: This strategy earns a Below Average Process Pillar rating because the senior loan market is not conducive to index investing. This market is illiquid, trading is still largely a manual process, and these loans often take more than a week to settle. They also carry considerable credit risk as they are primarily issued by issuers rated below investment-grade. It is difficult to closely hew to an index in this market, which limits the efficacy of the strategy. For example, although the fund’s tracking error over the trailing three years through April 2020 (0.81) was the best of any index fund in the bank-loan Morningstar category, it was about 3 times higher than the median tracking error for index funds in the high-yield bond category (0.18).
The fund tracks the S&P/LSTA US Leveraged Loan 100 Index, which includes the 100 largest senior loans and weights them by market value. Qualifying loans must have a minimum initial term of one year and a minimum initial spread of 125 basis points over Libor. S&P and LSTA review the index constituents at the end of each week to reduce the weighting of constituents that exceed 2.0% of the market-value weight of the index to 1.9%. The index undergoes a more thorough review semiannually. The loans must have at least $50 million in par value and be senior secured and denominated in U.S. dollars.
Portfolio: Because senior loans are typically issued by companies that are rated below investment-grade, the portfolio takes considerable credit risk. As of April 2020, over 80% of the fund’s assets were in date rated BB or B, which was in line with the bank-loan Morningstar Category average. However, these loans are secured against the assets of their issuers, which tends to give them higher recovery rates than most high-yield bonds.
Senior loans typically take at least a week to clear, while an ETF needs to offer daily liquidity. To address this mismatch, the fund usually holds around 10% of its assets in cash or cash equivalent securities. While this is in line with the category average, it can act as a headwind to the fund’s performance and cause tracking error to its benchmark. Additionally, the fund typically holds a position in publicly traded high-yield debt. This amount varies over time.
As the interest paid on these loans are tied to changes in Libor, the fund takes minimal interest-rate price risk. As of April 2020, the fund’s average effective duration was approximately 0.12 years.
Performance: The performance of the fund from its inception in March 2011 through January 2020 has not been compelling. It trailed its index and the category average by 68 basis points and 57 basis points, respectively, while exhibiting greater volatility.
The fund’s performance during the COVID-19 crisis was also unimpressive. Between Feb. 19, 2020, and March 23, 2020, the strategy fell by 20.72% while the category average fell by 19.66%. Complexities involved with indexing this opportunity set contributed to its poor performance during the period.
This portfolio is sensitive to changing credit spreads, given the low credit quality of its issuers, though not to the same extent as the broad high-yield bond market because its loans are secured. For example, when the ICE Bank of America US High Yield Master II OAS Index expanded by approximately 3% from June 2015 through February 2016, the fund fell by 5.50%, while the ICE Bank of America US High Yield Index fell by 9.41%. When the OAS contracted by approximately 3% from March 2016 through February 2017, the fund rose by 10.53% and the High Yield Index rose by 22.30%.
The fund’s benchmark sticks to the 100 most liquid senior loans, which makes it more feasible to index. But this also results in a less favorable performance because the fund cannot delve into smaller and less liquid issues, which may offer a premium as compensation.
Neal Kosciulek does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.