ETF Fervor Shifts to Loans

Funds see big inflows to buy speculative-grade loans as bonds lose luster.

Exchange-traded funds that amassed junk bonds at a record pace in the first half of 2012 are now attracting unprecedented cash to buy speculative-grade loans as investors wager that a four-year rally in the notes is ending.

Blackstone Group LP, the world’s largest private-equity firm, is planning its first ETF that will mostly buy loans, and Pyxis Capital LP, spun off from Highland Capital Management LP, announced its first such fund last week. Invesco Ltd.’s PowerShares Senior Loan fund, started two years ago as the first ETF solely dedicated to loans, has grown to become the third- biggest speculative-grade debt ETF with $1.2 billion of assets.

ETFs, which allow investors to speculate on securities without actually owning them, are shifting into floating-rate senior loans as concern mounts that junk bonds are losing momentum after gaining 114 percent since 2008. The gap between yields on bonds and loans has fallen to less than half the historic average amid the Federal Reserve’s actions to stimulate the economy.

“Loans are a compelling asset class compared to high yield at these levels,” said Jason Rosiak, the head of portfolio management at Pacific Asset Management, the Newport Beach, California-based affiliate of Pacific Life Insurance Co. “ETFs regardless of the asset class are becoming a more widely used vehicle to express a view.”

Flows into ETFs that buy bank debt reached a record $124.2 million in the week ended Oct. 24 and have accounted for 17 percent of all deposits into leveraged-loan funds since July, according to data compiled by Royal Bank of Scotland Group Plc. The average trading volume in PowerShares loan ETF shares has surged to 1.5 million over the past five days, almost three times the average over the past six months, according to data compiled by Bloomberg.

The five-biggest ETFs that focus on speculative-grade corporate notes have lost $1.61 billion of assets since reaching a peak of $32 billion on Sept. 20, while the funds that buy loans on such companies reported $467.6 million of deposits.

Yields on junk bonds were 42 basis points more than those on loans as of Nov. 9, according to JPMorgan Chase & Co. data. That compares with an average 103 during the past three years. Loans were paying as much as 13 basis points more than junk bonds in mid-September, the analysts said.


Easier Trade

Leveraged loans are the latest assets to benefit from ETFs that have attracted buyers from retirees to the biggest banks because they’re easier to trade than the underlying debt. Loans trade less frequently than bonds, are only available in over- the-counter markets to institutional investors and may take weeks to officially change hands after a sale. Shares of an ETF trade like stocks and prices are reported in real time.

“Investors have said they want another way to manage their portfolios,” said Diane Vazza, the head of Standard & Poor’s global fixed-income research in New York. “High-yield ETFs were a natural. Loans are an extension of that.”

Elsewhere in credit markets, Eastman Kodak Co. said it arranged $793 million in financing from some creditors to exit bankruptcy as a commercial-printing company by mid-2013. Firth Rixson Ltd., an aerospace-industry supplier of engineered metal, is said to be seeking $680 million of loans to refinance debt. British American Tobacco Plc raised 750 million euros ($953 million) in its first bond sale in the currency in a year.

The Markit iTraxx Europe Index, a credit-default swaps benchmark that investors use to hedge against losses or to speculate on the creditworthiness of 125 investment-grade companies, increased one basis point to 133 basis points at 12:05 p.m. in London. In the Asia-Pacific region, the Markit iTraxx Asia index of 40 investment-grade borrowers outside Japan fell two basis points to 123.

Credit swaps pay the buyer face value should a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million.

Centerbridge Capital Partners, GSO Capital Partners, UBS AG and JPMorgan Chase & Co. are among second-lien creditors participating in Kodak’s financing, which will be used during bankruptcy and can partly be converted to fund the emerging company, Rochester, New York-based Kodak said yesterday in a statement. The agreement requires court approval.


Firth Rixson

Funding is conditional on selling its patent portfolio for at least $500 million, which Kodak said it “is confident it will achieve.” Converting the debt for use by the emerging company requires progress in the sale of two business units, and the resolution of the company’s U.K. pension obligations.

Firth Rixson’s debt due in June 2017 will pay interest at 4.75 percentage points to 5 percentage points more than the London interbank offered rate, according to a person with knowledge of the transaction, who asked not to be identified because the information is private. Libor, a rate banks say they can borrow in dollars from each other, will have a 1.25 percent floor.

The Sheffield, England-based company is proposing to sell the debt at 99 cents on the dollar, the person said, reducing proceeds for the company and boosting the yield to investors.

British American Tobacco, Europe’s largest cigarette maker, sold bonds due in January 2023 to yield 75 basis points more than the mid-swaps rate, according to data compiled by Bloomberg, tighter than initial guidance of 80 to 85 basis points.

BAT’s sale is the company’s first in the common currency since it raised 600 million euros of 10-year bonds on Nov. 9, 2011 at a yield of 123 basis points more than swaps, data compiled by Bloomberg show.

Blackstone is working with State Street Corp. to create the Blackstone/GSO Senior Loan Portfolio, which will seek to invest at least 80 percent of its assets in leveraged loans and trade under the ticker SRLN, according to a filing with the Securities and Exchange Commission on Oct. 31.

The fund, which aims to return more than the S&P/LSTA U.S. Leveraged Loan 100 Index, will be overseen by Blackstone managing directors Daniel McMullen and Lee Shaiman, the document said. It differs from Invesco’s leveraged-loan ETF in that it will be actively managed, rather than seeking to mirror the returns of a benchmark index.


Junk Shift

Pyxis Capital, which is based in Dallas, and has $2.4 billion under management, started the Pyxis iBoxx Senior Loan ETF on Nov. 7, the company said in a statement. The fund, which trades under the ticker SNLN, seeks to track the returns on the Markit iBoxx USD Liquid Leveraged Loan index.

Investors funneled $568 million into U.S. leveraged-loan funds in the five days ended Nov. 7, the most since the week ended May 18, 2011, with $99 million going to ETFs, according to data compiled by RBS. The loan funds have reported $3.3 billion of inflows since Sept. 12 while junk-bond funds in the region reported $427 million of withdrawals, the data show.

In the first five months of the year, the biggest junk-bond ETFs increased their assets by $8.16 billion, Bloomberg data show.

“People are searching for yield,” said Deborah Fuhr, who helped found the London-based research firm ETFGI this year after heading ETF research at money manager BlackRock Inc. “It’s harder to find products that historically have been able to generate junk-bond level returns.”

Yields on speculative-grade bonds plunged to a record low of 6.84 percent on Oct. 18 before rising to 7.1 percent on Nov. 9, according to Bank of America Merrill Lynch index data.

Investment managers are increasingly turning to ETFs since it’s easier to allocate money by purchasing shares sold at $100 or less, Fuhr said. Bonds are typically available for sale in $1,000 increments.

The notes have had annualized returns of 22 percent since December 2008, when the Federal Reserve began holding its benchmark interest rates at zero to 0.25 percent. The central bank also plans to buy $40 billion of mortgage bonds a month in its third round of debt purchases aimed at igniting an economy that’s expected to grow at a rate of 2 percent next year, according to economists surveyed by Bloomberg.

Leveraged loans have returned 9.3 percent this year and 58 percent since 2008, when spiraling declines in mortgage values led to the demise of Lehman Brothers Holdings Inc.


Active Role

Loan investors usually play a more active role in determining new covenants protecting creditors than bond buyers and may choose to allow a company to amend existing deal documents, according to Robert Cohen, a senior credit analyst at Los Angeles-based DoubleLine Capital LP, which oversees $45 billion in assets.

Investors also may want their fund managers to have expertise in estimating the potential recovery on distressed credits from the leveraged-buyout boom from 2005 through 2007, which are a significant part of loan indexes, he said.

“All of these issues suggest that active management is the way to go,” Cohen said in an e-mail.

Invesco’s ETF has gained 8.7 this year, 0.64 percent less than the S&P/LSTA Leveraged Loan 100 Index that it seeks to match, Bloomberg data show. It has increased its assets by $1.1 billion this year with its share price rising $1.01 to $24.82, the data show.

“Because of the really strong demand for high-yield bonds that we’ve seen for the past year, they’re now yielding about the same as bank loans,” Rosiak said. “In the near term, I’d rather be higher up in the capital structure and floating-rate with loans.”


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