Bank loan ETFs are a useful component in institutional portfolios and can provide key exposure management benefits.
In the past few years, demand has soared for private market assets as investors have sought to enhance investment returns, protect against inflation, and diversify their portfolios. One of the biggest challenges for private market investors is managing liquidity – maintaining exposures, reducing cash drag, meeting capital calls, and adhering to asset allocation targets. This article is the third in a series about liquidity management tools to complement private market allocations.
Senior bank loan ETFs have been a useful component in institutional portfolios as investor policy goals and objectives are challenged by an inflationary environment that is influencing changes in the forecast returns of all assets. These fixed income ETFs invest broadly in floating-rate senior loans and seek to provide current income consistent with the preservation of capital. They can serve as a satellite to a core bond fund or as a complement to a high yield or private credit allocation.
Senior loans have a low effective duration, which helps to mitigate the mark-to-market volatility of a portfolio when interest rates are volatile. Duration is minimal because loan coupon payments consist of the Secured Overnight Financing Rate (SOFR) or the London Interbank Offered Rate (LIBOR), plus a stated spread. As such, senior loans have seen increasing yields with less volatility as compared to other fixed income asset classes.
With the yield curve likely to remain volatile as the Federal Reserve (Fed) attempts to balance inflationary pressure with economic growth and financial stability, senior loans may be attractive given this short duration. Additionally, senior loans may be more defensive than high yield given their higher average recovery rates historically.1
Private credit allocations have increased in popularity, promising enhanced returns in exchange for limiting liquidity. However, there are logistical challenges, particularly with drawdown-style funds. Given this, bank loan ETFs have proven to be apt complements to private credit allocations.
Senior bank loan ETFs are designed to actively manage industry and credit exposures based on technical and fundamental views while providing daily liquidity by secondary trading of ETF shares. In addition, to normal-way secondary trading, authorized participants (APs) often stand by to provide additional liquidity in ETF shares at institutional size. As such, even large positions in loan ETFs can generally be readily monetized to fund private credit fund capital calls as needed.
Although bank loan ETFs are not as liquid as the largest stock- or bond-based ETFs, they are still orders of magnitude more liquid than the private market closed end funds that call capital as deals are closed and often have terms of 5-10 years to achieve the higher target returns.
Building an allocation of 10% to private growth assets can take a number of years to achieve while managing diversification within the private credit allocation. One approach would be to invest the 10% earmarked for private credit into a liquid alternative, such as bank loans, and use this allocation to fund capital calls as they fall due. Over time, the bank loan allocation will tend to 0% as the private credit allocation increases towards target. We can estimate this path using our cashflow pacing model, an illustrative example of which is included in Figure 1.
In this example, the Bank Loan allocation is 0% in Year 5, but starts increasing in Years 9 and 10. It is impossible to maintain an exact 10% allocation as private credit investments are illiquid, capital is called when opportunities present themselves, and the allocation in percentage terms depends on how the value of the liquid assets change over time.
Senior bank loans play an important role within a total portfolio as a source of diversification, potential risk-return enhancement, and inflation protection. Senior bank loan ETFs provide a liquid complement to these allocations. Additionally, senior bank loan ETFs also provide a meaningful source of income for investors. Exposure and liquidity can be achieved by way of the ETF vehicle – either as individual portfolio components or as part of a multi-asset class customized solution.
We welcome the opportunity to discuss your portfolio’s liquidity and exposure needs. Please contact us for additional information or visit ssga.com to view thought leadership related to liquidity solutions.
1 Source: Blackstone Credit, J.P. Morgan Default Monitor Period: 01/01/2005– 12/31/2022.
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