Just five Canadian-listed ETFs make up the floating-rate-loan category. Over the past year, they’ve generated lofty yields in the range of 5–7%, much higher than the mainstream bond markets and more than double that of money-market funds.
Better still, they’ve done so by taking little duration risk, since payouts on the loans are adjusted frequently in line with changes in market interest rates.
But because of the credit risk that they take on — their holdings are primarily below investment grade — these ETFs are suitable for investors only as a high-yielding complement to core fixed-income holdings.
“Trying to avoid the losers is a really big job of ours,” said Konstantin Boehmer, senior-vice-president and head of fixed Income at Mackenzie Investments. He co-manages the Mackenzie Floating Rate Income ETF.
The Mackenzie ETF is a near-pure play on senior loans, which constitute about 90% of the portfolio. At last report, its annualized yield was 6.3%. Its duration, a measure of interest-rate risk, was 0.18 years. Though senior loans are mostly originated in the U.S., nearly all of the fund’s portfolio is hedged back to the Canadian dollar.
The emphasis is on first-lien loans from companies that Mackenzie’s credit analysts conclude are able to meet their payment obligations. First-lien loans rank higher in a company’s capital structure and therefore lenders will have a higher recovery rate in the event of a default.
Over the past year, Mackenzie’s small holdings of second-lien loans — along with holdings in loans restructured through liability management exercises — detracted from performance. Its one-year return to May 31 was 3%, down from the three-year return of 6.1%.
Boehmer and co-manager Dan Cooper, who assumed full responsibility for portfolio management on May 12, have tightened up selection criteria and slightly reduced the number of positions in order to monitor them more closely.
Even so, the ETF still holds about 250 positions, the vast majority of which are below investment grade, and all below 2% of the portfolio.
“Diversification is the key,” said Boehmer. “We do not want to have overly concentrated bets on individual names in that higher yielding space.”
A broader strategy
The CI Floating Rate Income Fund pursues a broader strategy. It holds only about half its portfolio in senior loans, though that’s double the minimum 25% to meet the Canadian Investment Funds Standards Committee’s category definition.
The fund’s strategy combines rigorous bottom-up credit selection, aimed at avoiding loan defaults, along with disciplined portfolio construction, said portfolio manager Darren Arrowsmith of CI Global Asset Management. The ETF recently yielded 5.9%. Through May 31, it has a total return of 5.1% over one year and an annualized 7.3% over three years.
“It’s not simply picking the highest yielding sub-investment grade loans, and just driving forward from there,” said Arrowsmith, who specializes in high-yield fixed income. “The bottom-up credit analysis is based on large, high-quality companies with larger equity cushions, typically lower loan-to-value [ratios], and better free cash flow.”
The other half of the portfolio consists of a diversified mix of securities such as floating-rate bonds, short-duration investment-grade bonds, high-yield bonds with call provisions, fixed-to-floating-rate hybrids and preferred shares with near-term redemption or call provisions.
The goal, said Arrowsmith, “is to construct a portfolio of high-conviction ideas across core catalyst-driven and yield-to-call positions that tend to provide consistently strong risk-adjusted returns.”
The CI ETF’s duration, at about half a year, is higher than for a pure senior-loan portfolio. About 70–80% of the portfolio is below investment grade, Arrowsmith said, and usually 90–95% of the currency exposure is hedged back to the Canadian dollar.
Other funds
Two other offerings in the category are First Trust Senior Loan ETF (CAD-Hedged) and IA Clarington Loomis Floating Rate Income Fund. Both invest about 80% of their portfolios in senior loans. Their holdings are nearly all below investment grade.
The IA Clarington fund has been a performance laggard, returning 1.9% over one year to May 31, and an annualized 1.6% over five years. First Trust’s was the only money loser in the first five months of this year, down 0.2%. Its 10-year return is a below-average 3.3%.
The fifth ETF in the floating-rate loan category is the BMO Floating Rate High Yield ETF, an oddity since it doesn’t hold any senior loans. Instead, its portfolio consists of high-yield credit-default swaps and a ladder of Canadian treasury bills that effectively hedges away almost all U.S. currency exposure.
“While senior loans are senior to the credit risks that we are taking [in the ETF], one of the challenges in trading senior loans — the actual loans themselves — is settlement risk,” said Matt Montemurro, head of fixed income and equity index ETFs with BMO Global Asset Management.
He said senior loans can take up to T-plus-16 to settle — the day of the trade plus 16 business days. This presents challenges for ETFs that have a T-plus-one settlement requirement.
Since the clearing broker for the swap contracts is Intercontinental Exchange Inc., known as ICE, said Montemurro, “what that allows us to do is trade on a much more liquid scale than you would in senior loans in periods of high volatility.”
The synthetic approach hasn’t prevented significant drawdowns during periods of high volatility. In the first quarter of 2020, when financial markets were reeling amid the Covid crisis, senior loans took a hit.
So did the BMO ETF, losing 14.2% in the three months ended March 2020, worse than the 13.4% loss for its loan-heavy Mackenzie rival.
Montemurro said the BMO portfolio is slightly lower-rated than one consisting of first-lien senior loans. Otherwise, he added, the outcome of BMO’s credit-default swap exposure is similar to that of a senior loan portfolio.
One advantage the BMO ETF enjoys by not having to research and trade in senior loans is lower costs. Its management-expense ratio (MER) is 0.44% — the lowest of its peer group. Investing through swaps contributes to that relative low MER, said Montemurro.
Though its returns aren’t directly comparable to rivals that actually hold senior loans, the BMO ETF has been a consistent top-quartile performer over the one-, three-, five- and 10-year periods ended May 31.
The fund’s 10-year annualized return is 5.8%. “It’s an excellent complement as a way to enhance yield without increasing interest-rate sensitivity risk,” Montemurro said.