Institutional investors, including pensions and insurance companies, poured some $56.3 billion into loan participation passive mutual funds and exchange-traded funds over the summer, looking for a safe place to park cash until equity markets could regain their footing amid wariness of quantitative easing and interest rate manipulation.
Data shows that in their pursuit of lower risk, institutions pulled their money out of fixed-rate bond ETFs. Since the beginning of June, floating-rate loan funds have received cash inflows of $1.92 billion, while investment-grade fixed-rate ETFs have lost $1.47 billion in fund flows, according to Carol Chen, an ETF analyst for financial data provider Markit Group in New York. But the flows into such short-term bets are prone to fluctuate. (Read more: “Bond ETFs Help Melt Illiquid Markets”)
So far this quarter flows into floating-rate funds have decreased dramatically from the summer rush, when loan-based or floating-rate funds made huge gains in assets under management. BlackRock’s iShares Floating Rate Bond ETF (FLOT) led the way in the third quarter, picking up $1.4 billion in new cash; it had total assets under management of $3.6 billion as of September 30. In the same period Invesco’s PowerShares Senior Loan Portfolio ETF saw its assets increase by $1.3 billion, to $5.8 billion.
Most of these securities have coupons that reset every three months. A portion of Van Eck’s Market Vectors Investment Grade Floating Rate ETF (FLTR) resets within any month, as the various 3-month (90-day) notes mature. Also, instead of having its underlying index based on market-cap-weighted equities, FLTR is weighted toward low-risk, high-rated corporate bonds with longer-term durations of two to five years, says the ETF’s New York–based portfolio manager, Francis Rodilosso. “The near-zero duration offers investors less interest rate risk than traditional bonds with fixed rates,” Rodilosso says. “This fund is designed to have a higher yield in exchange for greater price sensitivity to movement in credit spreads.” As a point of comparison, FLOT and the SPDR Barclays Investment Grade Floating Rate ETF (FLRN) have bonds of a duration of two years or less.
With the lower interest rate risk comes lower yields, of course — a trade-off that investors squeamish about volatility in Treasury bills appear to have accepted. “They remained pretty comfortable with corporate credit risk but want to limit their interest rate risk,” observes Rodilosso. As of October 11, FLTR had a 30-day SEC yield of 0.61 percent, higher than both the iShares FLOT’s 0.35 percent yield and FLRN’s 0.42 percent. All three ETFs have expense ratios at or below 20 basis points.
But some fixed-rate bond ETFs have attained yields of more than 2 percent. At the end of April, iShares Core Total U.S. Bond Market ETF (AGG) had a 30-day yield of 2.8 percent, and it yielded 2.22 percent during September, notes Jeff Tjornehoj, head of Americas research at Lipper, working in Denver. AGG offers an investment-grade portfolio with low credit risk and an interest rate risk higher than that of the floating-rate funds. Even so, AGG’s net asset value has dropped from $111.33 on April 23 to $106.88, which Tjornehoj attributes to heightened fears this summer over tapering. Most bond prices took a beating. “Distributions on AGG are at an all-time low,” he says. “It could be a good contrarian indicator.”
The floating-rate ETF yields also pale compared with those of actively managed mutual funds, whose managers are free to move funds among various types of loans, such as collateralized loan obligations and second-lien loans. Though riskier, the funds tend to return much higher yields. As of October 22, Highland Floating Rate Opportunities (HFRAX) was up 12.7 percent year to date; it had a 30-day yield of a relatively staggering 4.43 percent as of September 30, notes Tjornehoj. But he points out that HFRAX is also memorable for the 44 percent nosedive it took in 2008.
Overall, loan-based mutual funds and ETFs have not emerged from the fluctuations of this summer unscathed. During the 16-day government shutdown earlier this month, fund flows into low-risk floating-rate ETFs dropped off somewhat, likely on the back of bearish sentiment, according to Markit’s Chen.
Read more about ETFs.
