With one exception, the few floating-rate loan ETFs that trade in Canada have few assets. But in an environment of rising rates, these specialty income products appear well positioned to take on a higher profile.
First, they’re an unusual combination of high yields and very short duration, meaning they’re far less vulnerable to interest rate increases than conventional fixed-income securities such as government bonds or investment-grade corporate issues.
Because of these characteristics, floating-rate loans have low correlations to the mainstream bond markets, thus providing diversification. Another positive attribute is that in the event of a default, senior loans have a higher recovery rate, since they rank at the top of the capital structure in terms of claims on corporate assets.
Secondly, there’s aggressive new competition in the category from CI Global Asset Management, which in April rolled out an ETF series of the CI Floating Rate Income Fund, an actively managed mutual fund launched five years ago. Another firm, Toronto-based Brompton Funds Ltd., is considering converting to an ETF its closed-end senior-loan fund, which has a strong decade-long track record.
Facing an established competitor in the $1.1-billion Mackenzie Floating Rate Income ETF, whose assets at the end of May were more than triple the rest of the competition combined and which has a four-star Morningstar Rating for risk-adjusted returns, CI chose to compete on price as well as on performance.
With a management fee of 0.35%, and a projected management expense ratio of 0.57%, CI Floating Rate becomes the second cheapest in the category, after the BMO Floating Rate High Yield ETF (management expense ratio: 0.45%). By comparison, Mackenzie’s MER of 0.67% is modestly higher than CI’s.
CI Floating Rate lacks any meaningful track record as an ETF, but its holdings and strategy are identical to the Morningstar five-star rated mutual fund, also co-managed by CI senior vice-president and senior portfolio manager Geof Marshall and vice-president and portfolio manager Darren Arrowsmith.
Though more than half of the portfolio’s assets are in senior loans, the managers also hold other income securities such as floating-rate bonds, floating-rate preferreds and a small portion of investment-grade short-duration bonds.
The mutual fund’s outperformance over the past five years has come by taking less credit risk than many of its competitors, Marshall said. “You never want to be jammed into one corner or one asset class and not be able to use different levers to preserve capital in a tough market.”
As is normal for its category, the CI ETF’s portfolio is below investment grade. Arrowsmith said the weighted-average credit rating is approximately BB-, higher than the single-B rating for the senior loan universe as a whole.
One of the managers’ strategies has been to invest selectively in higher-rated but still high-yielding securities that, unlike senior loans, are subordinated debt. “By doing this you’re taking higher recovery-value risk but lower default risk,” Arrowsmith said. “So we’ve been able to improve credit quality on average of the fund versus peers without giving up return.”
Marshall contends that active investing is necessary for securities such as high-yield bonds and senior loans because of how debt indexes are structured. “In the equity market, your biggest weights are your fastest growing, most profitable companies. In the loan market, your biggest weights are the companies with the most debt,” he said. “Whether it’s in the high-yield bond market or in the loan market, the biggest driver of outperformance tends to be avoiding your losers, avoiding defaults.”
The oldest floating rate ETF is the 10-year-old currency-hedged version of the Invesco Senior Loan Index ETF. The only one in the category to employ an indexing strategy, it seeks to replicate the performance of the S&P/LSTA U.S. Leveraged Loan 100 Index.
Along with having a below-average MER of 0.73%, the Invesco ETF is a purer and more holdings-transparent play than its competitors. Its weighted-average yield to maturity is 5.27%, indicative of the credit risk of a below-investment grade portfolio.
However, since the ETF tracks the 100 largest and most liquid loans out of a universe of more than 1,000 issues, it has a higher allocation to BB- and single-B-rated loans than those rated CCC, said Darim Abdullah, vice-president and ETF strategist with Toronto-based Invesco Canada Ltd. “It does focus on higher quality and better liquidity issues within the loan market.”
The default rate on senior loans averaged just 2.6% over the past 21 years, Abdullah said. He added that among those defaults, the average recovery rate for lenders has been 63%. “The fact that these underlying loans are senior, secured by collateral and rank at the top of the payback order, with a very low default rate, creates that risk mitigation.”
Among other exchange-listed products is Symphony Floating Rate Senior Loan Fund, a $90-million closed-end fund sponsored by Brompton Funds. Managed by Chicago-based Nuveen Asset Management LLC by personnel based in San Francisco and North Carolina, the leveraged fund’s average annual return since inception in November 2011 is a relatively high 5.4%.
“Occasionally you will see spikes in defaults, which speaks to the need for active management in a senior loan investment,” said Brompton’s Chris Cullen, senior vice-president and head of ETFs.
Cullen said that since loans tend to be a little more stable an asset class because of their seniority in the event of issuer default, the fund has employed leverage since inception to enhance yields.
Typically, the fund’s leverage is about 35%, to a maximum of 40%. While implying higher risk, leverage enables Symphony Floating Rate to generate yields exceeding 6%, higher than other floating rate funds.
For the time being, the Symphony fund doesn’t compete head to head in the ETF space, and its units can trade at either a premium or discount on the Toronto Stock Exchange. “Conversion to an ETF is under consideration,” Cullen said. “But we haven’t made a firm commitment to that yet.”