Demand for exchange-traded funds investing in pre-emptive loans has skyrocketed this year as investors seek respite from rising inflation.
The sector has invested $ 7.3 billion this year, nearly doubling its asset base to $ 16 billion, according to CFRA Research.
This trend is associated with rising inflation and interest rate expectations in the US and elsewhere, prompting investors to prioritize floating rate loans over fixed rate bonds.
“This is a long-term model,” said Ben Johnson, director of global ETF research at Morningstar. “This is almost a barometer of investor expectations regarding the future direction of interest rates. When people are worried about the possibility of increase, we see capital inflows. “
“Demand for pre-emptive ETFs has skyrocketed in 2021 as investors have become more comfortable investing in fixed income ETFs,” added Todd Rosenbluth, head of ETF and Mutual Fund Research at CFRA. “They are less sensitive to the interest rate than traditional loans.”
Priority lending ETFs invest in speculative grade securities, as do high-yield funds that have recently seen an outflow of funds, but which offer higher returns to investors who are underperforming. However, funds hold securities that are older in the capital structure and exhibit less volatility.
Although priority ETFs accounted for just 0.6 percent of global fixed income assets at the start of the year, they accounted for 6.5 percent of net inflows in 2021, according to CFRA and ETFGI, a consulting firm.
The numbers indicate a sharp reversal of fate. Bill Ahmouti, head of the fixed-income group at State Street Global Advisors, said there was about $ 65 billion in net outflows from mutual funds and ETFs from late 2018 to late 2020.
“In August / September last year, the opinion of the population about tariffs began to change. We started to see the growth of long-term rates. That’s when we changed course and started seeing a return to asset class, ”he said.
“They are looking to shorten their portfolio to move to floating rate products.”
Net inflows through senior loan mutual funds and ETFs reached $ 20 billion this year, with ETFs accounting for a disproportionately large share, which he attributed to the stable performance of the fund structure during last year’s volatility spike caused by Covid, Ahmouti said.
ETF SPDR Blackstone Senior Loan (SRLN), the second-largest ETF in this category, has tripled its holdings to $ 6.5 billion this year. Pension funds, wealth advisors, insurance companies and even credit managers have all taken part, using the fund to quickly gain access to an asset class.
According to the SPDR, loans have historically had volatility of 5.8% per annum compared to 7.7% for high yield bonds. Average yields are usually slightly lower for older bonds, at 3.7 percent compared to 4.2 percent for high yield bonds.
However, they tend to invest in less liquid securities and tend to charge higher fees. ETF Invesco Senior Loan $ 6.7B (BKLN), the largest fund in the sector, had an expense ratio of 0.67%, while SRLN Blackstone had 0.7%.
A significant proportion of pre-emptive loan ETFs are actively managed, including the SRLN, First Trust Pre-emptive Loan ETF (FTSL) and the Franklin Liberty Senior Loan ETF (FLBL). According to Rosenbluth, about 57% of priority lending ETF assets are active, which is an unusually large number considering that 90% of the broader fixed income ETF market and 96% of all ETF assets are passively managed.
Loan illiquidity “lends itself better to discretionary management than indexation,” adding that “active managers do not have a hard time doing better than the benchmark,” Johnson said.
Rosenbluth said active funds have higher exposure to triple C and single B lower tier loans than passive ETFs, helping them outperform yields by about 1.5-2 percentage points this year.
“Active managers take on greater credit risk within the priority lending space. Active managers conduct their own analysis of credit risk and default, ”he said.