Tick, tick, tick…there might be another big potential threat to market stability looming, this time within the exchange-traded fund (ETF) arena.
Leveraged-loan ETFs are making investors and analysts alike nervous as money begins to flow out of them at a rather alarming rate. According to this article in the Wall Street Journal, investors have hauled their money out of ETFs backed by bank loans for three weeks in a row to the tune of $107.5 million—outflows that haven’t been seen since the first leveraged-loan ETF was launched back in 2011.
That’s raising questions about how a mass exit of investors could impact the market for those loans (and presumably the folks who issue them). Leveraged loans are given to companies that already have a lot of debt on the balance sheet—it’s higher risk to the lender and, hence, commands a higher interest rate.
ETFs based on leveraged loans were hot last year and experienced record inflows. A sharp reversal of that has investors worried about what it could do to the market for the underlying loans.
It’s a big problem for ETF investors who expect to trade their shares in real time, like stocks. The leveraged-loan market isn’t exactly liquid—quite the opposite, in fact.
Settlement times for leveraged loans recently hit a of 23.4 days.
That’s a far cry from a liquid market—and it represents a pretty big mismatch between the liquidity needs of the average ETF investor and the nature of the underlying investment. (You don’t need a PhD in finance to figure out that real-time trading on products that take more than three weeks to settle might be a bit problematic.)
Other investors have been making high-profile comments on the subject of leveraged-loan ETFs (and on leverage in general). Back in February, Justin Gmelich, head of credit trading at Goldman Sachs, bubbling up from increased inflows into leveraged-loan products.
In fact, last week, BlackRock CEO Larry Fink blasted the use of any leverage at all in an ETF—he said that structural problems within leveraged ETFs in general could one day “blow up” the whole industry.
There are a couple of reasons this whole discussion reminds me of the asset-backed commercial paper (ABCP) crisis here in Canada. Back then, investors were snapping up ABCP as a short-term holding, without understanding that at least a portion of the underlying assets weren’t liquid enough to keep up.
With leveraged-loan ETFs, the liquidity mismatch between the product and the underlying assets seems way more obvious. It’s all about trying to squeeze illiquid assets into liquid products—it can be a pretty painful fit when something goes wrong.