Floating-rate ETFs, which have yields that are double to triple those of three-month Government of Canada treasury bills, could be an appealing alternative for income-seeking clients.
Unlike conventional fixed-income securities — such as investment-grade government and corporate bonds, whose prices move in the opposite direction of interest rates — floating-rate loans are insulated from rising interest rates. If interest rates move higher, so do the yields on floating-rate loans.
Even so, these higher-yielding securities should by no means be considered a substitute for money market instruments or cash deposits. By definition, the average credit quality of portfolios in the floating-rate category for both ETFs and mutual funds must be below investment grade.
Horizons Active Floating Rate Senior Loan ETF, which Toronto-based Horizons ETFs Management (Canada) Inc. launched in October 2014 and Montreal-based AlphaFixe Capital Inc subadvises, illustrates the yield advantage of floating-rate loans. For example the ETF’s estimated annualized yield was 5.1% compared with 1.73% for 91-day Canada T-bills during the three years ended Oct. 31, says Sébastien Rhéaume, AlphaFixe’s managing director. That translates into a spread of 337 basis points (bps).
Although this spread is substantial, it’s narrower than it has been on average, historically. Citing data for the Credit Suisse leveraged loan index, the monthly yield spread over 91-day T-bills, measured over all three-year periods dating back to 1992, has averaged around 460 bps, Rhéaume says.
This yield spread has varied widely over time. During the 2008-09 global financial crisis, the spread shot up to a high of about 1,300 bps. At the other extreme, says Rhéaume, the spread’s lowest level was 230 bps in April 2006.
Senior loans provide diversification as well as yield enhancement, complementing core holdings in high-quality, longer-duration fixed-income assets, says Chris Franta, director of U.S. fixed-income product management with Franklin Templeton Investments in San Mateo, Calif. But there is a risk/reward tradeoff. “We are essentially substituting interest rate risk for credit risk,” he says.
A three-member Franklin Advisers Inc. team in California that includes Mark Boyadjian, head of Frankin Advisers’ floating-rate debt group, is responsible for managing Franklin Liberty Senior Loan ETF (CAD hedged), which Toronto-based Canadian affiliate Franklin Templeton Investments Corp. sponsors. (The team of three portfolio managers is backed by seven bank loan analysts who are part of the broad Franklin Templeton fixed-income group.)
The yield spread, which rewards investors for assuming greater risk, will vary according to the loan’s credit quality. Currently, the spread is wider than its historical norm for CCC-rated loans, the lower tier of credit quality, while at about historical norms for the more credit-worthy B and BB tiers, Franta says: “We try to outperform primarily through superior securities selection. We pay little attention to what’s in the benchmark.”
Launched this past May, the $10-million Franklin Templeton ETF is the newest in its category. The ETF currently has a 4.4% annualized yield and 33 holdings. As the ETF grows larger, says Franta, the team expects to have exposure to 45-65 issuers eventually, even though the number of specific loan holdings will be higher.
Despite having credit ratings that are below investment grade, senior floating-rate loans offer other types of default protection. They rank ahead of bonds in the event of a financial collapse. Also, senior loans typically are secured by specific collateral rather than the issuer’s general credit.
However, during adverse market conditions, the value of the collateral may fall below the amount of the loan, or may be difficult to liquidate. Settlement periods for loan transactions tend to be longer, assuming that there’s a willing buyer. For all these reasons, bank loans would be unsuitable as direct holdings for retail investors, even if they were available.
Active portfolio managers such as AlphaFixe employ multiple strategies to diversify while seeking to mitigate default risk. “At all times, we only invest in bank loan instruments that are first lien and secured,” says Rhéaume of the Horizons ETF, which currently holds about 50 loans vs the more than 1,000 constituents in the Credit Suisse leveraged loan index. “We do not invest in second lien loans even if they are secured by assets.”
AlphaFixe’s management style is based on fundamental analysis with a quality bias, Rhéaume says. Although AlphaFixe always avoids the lowest-quality loans, the company currently has increased its emphasis on preserving capital.
“At this point in the cycle, we have positioned the portfolio more conservatively by increasing the average credit rating of the portfolio,” Rhéaume says. “We have increased our investments in BB and BBB tranches in order to be ready to face an economic downturn within the next 18-24 months.”
To lessen the Horizons ETF’s liquidity risk, AlphaFixe invests only in bank loans that have outstanding amounts of $500 million or more. Says Rhéaume: “In an uncertain economic climate, loan transactions of smaller tranches tend to trade on appointment with a significant discount.”
Most of the six Canadian-listed ETFs in the floating-rate loan category are actively managed. The exception is Toronto-based Invesco Canada Ltd.’s Invesco Senior Loan Index ETF (CAD hedged), which also is available in unhedged and U.S. dollar versions. The ETF’s reference index is the S&P/LSTA U.S. leveraged loan 100 index, which also is the benchmark for the actively managed First Trust Senior Loan ETF (CAD hedged) and for the largest ETF in the category, Toronto-based Mackenzie Investments’ $803-million Mackenzie Floating Rate Income ETF.
Given that the fund measurement industry’s definition requires that only 25% of the portfolio be invested in non-investment-grade floating-rate loans, an ETF that qualifies in the category isn’t necessarily a pure play. That’s especially true of Toronto-based BMO Asset Management Inc.’s BMO Floating Rate High Yield ETF. This $433-million ETF, the second largest in the category, takes more of a basket approach, gaining exposure through derivatives rather than direct holdings of floating-rate securities.