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Junk bonds are the hot investment vehicle – of 2012. This year's darling is leveraged loans, the low-rated corporate debt that sits atop bonds in a company's capital structure (lenders are repaid before bondholders in bankruptcy).
At 5.4 per cent on average in the U.S., according to Capital IQ, these investments pay an attractive yield. But their big selling point is their floating-versus-fixed interest rate. With U.S. Treasury yields rising off of all-time lows, floating-rate investments can provide a hedge. More than $8-billion (U.S.) has flowed into U.S. funds specializing in loans this year, taking the total assets under management to $82-billion.
Exchange-traded funds represent a tiny sliver of that. And there are $550-billion in leveraged loans outstanding. With loans all the rage, the popularity of ETFs is growing. Loan ETF assets have doubled to more than $2-billion since last October, nearly all of them in the PowerShares Senior Loan Portfolio (BKLN).
ETFs are generally cheaper than open-end mutual funds – BKLN's expense ratio is 76 basis points versus an average of 1.2 per cent for the mutual funds tracked by Morningstar – and investors can buy or sell them intraday. Recent demand had driven many closed-end funds that buy these loans to large premiums.
If loan ETFs keep growing, they could face some of the same concerns as junk bond ETFs – that they encourage short-term trading and volatility in a market where liquidity can dry up quickly, potentially leading to price swings in certain areas. But it is too early to worry about that now. There are other issues that all loan investors should keep in mind, though.
Leveraged loans can be refinanced, typically at 100 cents on the dollar after the first year. That limits the upside. And, if rates fall or a company's prospects improve, investors may find themselves with zero-yielding cash to reinvest. When Libor collapsed as a result of the financial crisis, banks began setting limits, or floors, on the benchmark rate when pricing new loans to limit the downside. More than two-thirds of the leveraged loan market has these "Libor floors" and will not benefit from the first 100 basis points of rates increases when higher rates come back in vogue.