Investors should beware leveraged loan ETFs as rainy days return, warns Kames Capital

London – Investors should be wary about the outlook for leveraged loan ETFs as financial conditions begin to tighten, with the risk of a spike in outflows within the asset class, Kames Capital’s Mark Benbow says.
Benbow, co-manager of the Kames High Yield Bond fund, says investors must be vigilant about the risks, as tighter financial conditions could rapidly impact performance and reverse the vast flows into the sector which were made via ETFs.
The figures are stark. At the start of 2000, there were only 15 ETFs or mutual funds dedicated to the leveraged loan asset class, but this has ballooned to almost 300 today amid rising interest rate expectations.
“The theory goes that rising interest rates will generally hurt (fixed coupon) bond markets, but leveraged loans (as floating rate instruments) will benefit as central banks unwind balance sheets and increase interest rates,” says Benbow.
However, while the fundamentals were positive last year, the nature of many of the investments in the leveraged loan market means liquidity is very limited, creating issues for any products which offer instant redemptions.
“The main holders of leveraged loans remain CLOs (collateralised loan obligations) and investors in CLOs have their money locked-in. They need a secondary buyer of their share of the CLO to redeem their exposure, while ETFs and mutual funds promise instant access to liquidity despite many of the loans rarely trading,” he says.
How this scenario unfolds is not yet clear, but Benbow warns in a worst case event, the outlook for recovering capital from failing loans is downbeat following a deterioration in the type of debt being bought.
He says although loans typically rank higher than bonds when borrowers go bankrupt, meaning that the recovery rate is higher, recently more than 50% of loans issued have had no junior borrowers to take the first hit. As a result, he says historic recovery rates of around 75% may be an over-estimate.
Indeed, according to a recent Moody’s report, second line recoveries are expected to fall from 43% to just 14% as many loans are increasingly found at the bottom of capital structures.
“Given the strength of the economy, many of these facts were either not acknowledged or were deemed something to worry about on a more rainy day,” he says.
“Well, that rainy day could well have arrived as we have seen financial conditions begin to tighten over the last few months, and with this there have been outflows within the leveraged loan asset class.”