Nothing screams shadow banking quite like a leveraged loan ETF

Nothing screams shadow banking quite like a leveraged loan ETF

Tracy Alloway

| Aug 27 09:15 | 2 comments | Share

They are billed as a quick and easy way for investors to gain access to higher-yielding assets while still providing some protection if interest rates start to rise. They are ETFs which track portfolios of (floating-rate) bank loans. And they are on fire. USA Today reported in May that the PowerShares Senior Loan Portfolio (BKLN), for instance, has become one of the best-selling ETFs this year, ballooning to $4.2bn in size “after raking in about $2.7bn of fresh assets so far this year.”Now, such loans could be considered a peculiar thing for ETFs to track since they generally exchange hands “on assignment” – meaning the fund literally becomes “a lender under the credit agreement with respect to the debt obligation,” per the BKLN’s prospectus. In other words, the ETF becomes a direct signatory to the loan. This means the authorised participants (APs) which support the funds typically can’texchange ETF shares for a basket of the underlying securities (in this case, those loans), as they would usually do for other types of ETFs. They can only exchange for cash.

This, unsurprisingly, leaves loan ETFs particularly exposed to any hiccups in the cash redemption process.

Hiccups, which happen to have occurred somewhat recently.

Here’s Barclays’ credit analysts, led by Brad Rogoff, in a piece of recent research:

News reports of a temporary moratorium on cash redemptions in municipal bond ETFs prompted a lot of questions in other parts of the credit market. The moratorium followed a period of brisk price declines and a subsequent wave of redemption requests … Loan ETFs have been increasing assets rapidly and are 220% larger since that report (from an admittedly low base). Given that share creation and redemption for loan ETFs is done exclusively in cash at the moment, concerns arose about whether a similar situation could occur in the loan ETF market. Since loans trade on assignment – which explains why the ETFs do not create and redeem in kind – we do not believe loan ETF administrators could turn off cash redemptions for any period of time. While loan ETF administrators could potentially execute in-kind redemptions with certain counterparties, in general, they would have to raise the required cash to meet redemptions as they arise. We suspect that this additional constraint at least partly explains why loan ETFs carry such high cash balances, which act as a reserve in case of significant outflows. Such large cash balances, while necessary preparation for a rainy day, will naturally cause some drag on an asset class with already-limited upside. Definitions of shadow banking are notoriously nebulous, but you could easily say (as the Financial Stability Board did last year) that any vehicle providing credit and leverage, and which falls outside the realm of traditional regulated banking, fits the bill. In which case, loan ETFs tick all the boxes plus one other – the promise of liquidity transformation through sunshine and rainy days.