A recent Barron’s article on the potential for serious trading problems in bank loan ETFs got me curious about the current state of trading in the space.
Brendan Conway’s balanced piece notes that the underlying securities are not as liquid as typical stocks, or even some bonds. He quotes some industry movers who fear that a mass exodus from funds like the PowerShares Senior Loan ETF (BKLN | B) could cause serious pain for investors.
This downside risk is real, but in my view, it’s best thought of as tail risk:an unlikely event with bad results if it does occur.
I say this because the fund has proven itself able to withstand ordinary downturns and outflows with minimal disruption to its robust daily liquidity.
The fund trades more than $50 million most days—2 million shares or more—at extremely tight spreads of 4 basis points. Trading in the ETF is so strong that it transcends the liquidity of the securities in its basket—a phenomenon we’ve seen played out across leading ETFs.
For example, take a boring basket of capitalization-weighted U.S. small-cap stocks, like the iShares Russell 2000 ETF (IWM | A-78). The massively liquid fund trades at tiny 1 basis-point spreads. Its top five holdings trade at an average spread of 11 basis points and the bottom five holdings—which receive much less weight—average 77 basis points, based on a quick snapshot.
This back-of-the-envelope figuring makes the point that the liquidity of the small-cap ETF is stronger than the sum of its parts, just as we see in BKLN.
Garden-variety outflows have already occurred in the fund’s history without producing a major—or even minor—disruption in liquidity. Outflows of about $150 million in the last week of June 2013—when “taper talk” moved global markets—had essentially no impact on the fund’s tight 4 basis-point bid/ask spreads. The same holds true for the more recent outflow of about $123 million on Aug. 1, 2014.
Beyond spreads, premiums and discounts can reflect disruptions from outflows and downturns. Premiums and discounts compare the market price of the fund to its intrinsic value, represented by the fund’s net asset value (NAV).
True, BKLN has swung from a persistent premium to a persistent discount starting in April, when small outflows started to occur. However, the range is small, with a maximum discount of -38 basis points for the year.
Last year’s maximum discount was a 67 basis-point downward spike in August. If you happened to sell on that spike after having bought at the prevailing 9 basis-point average premium since Jan. 2, 2013, you would have taken a hit of 76 basis points on top of whatever gain or loss in NAV. That’s not pleasant, but it’s not a major illiquidity event either.
It’s also worth noting that the NAV or intrinsic value of the fund may be less reliable in a major crisis.
The whole thesis of the trading risk here is poor liquidity of the underlying assets. Poor liquidity means weaker price discovery for each loan in the portfolio. In a major downdraft, the price of the highly liquid ETF could be a better measure of the true value of the portfolio than the sum of the stale prices of the securities in its basket.
Still, while the likelihood is remote in my view, the downside trading risk is real, and it could come in two flavors.
A Bad Day, Two Ways
If there were a truly massive rush to exit the fund—perhaps in the context of a major market meltdown—the lesser of the two bad outcomes would be where spreads for the fund could widen to the approximate aggregate of the underlying bonds, or a bit wider, whatever that may be. This would likely be accompanied by substantial apparent discounts, which again may indicate little more than stale pricing of the underlying loans.
This outcome is akin to trading at the true liquidity of the underlying basket, albeit at a time of crisis, in a basket that’s not terribly liquid. While this reality wouldn’t be much fun to live through—especially compared with the excellent liquidity currently enjoyed by the fund—I wouldn’t characterize that possibility as blowup risk for the ETF.
The worse of the two bad outcomes is one where a squeeze in the fragile underlying liquidity disrupts the ETF’s creation and redemption mechanism.
In such a scenario, premiums and discounts can reach extreme levels since market participants have no way to arbitrage share price and fair value. In short, BKLN would act like a closed-end fund—one where the underlying assets are stressed—until the create/redeem process was restored.
The bottom line is this:BKLN consistently trades well and will likely continue to do so even through modest trading shocks. In a major downturn however, the fund could trade more like its basket of hard-to-trade loans, or like a closed-end fund.
At the time this article was written, the author held no positions in the securities mentioned. Contact Paul Britt at firstname.lastname@example.org or follow him on Twitter @PaulBritt_ETF.
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