$150 Billion Bet: Wrong Place To Stretch For Yield
Retail yield chasers now have more than $150 billion riding on a risky income play that sure doesn't seem to provide commensurate reward opportunity. While junk-quality bank loans got some ink recently for net outflows in May, the $1.7 billion in outflows Morningstar (MORN) reported was barely a blip when measured against the $42 billion in net flows for the 12 months through May. Combined assets for retail bank loan funds and ETFs are now more than $150 billion.
Here’s what investors in the largest bank loan retail portfolio, the $7.2 billion PowerShares Senior Loan ETF (BKLN), earned in the 12 months through May, compared to the high-grade (read: boring) iShares Barclays Core Total U.S. Bond ETF (AGG):
That’s pretty much all a function of yield, as the bank loan ETF has a trailing 12 month payout near 4.5%, compared to 2.2% for the high-grade portfolio that tracks the benchmark Barclays Aggregate Composite bond index of corporate and government issues.
While 4.5% might seem like some sort of relative triumph in today’s low rate world, it’s anything but. In November 2012, right around when bank loan fever started to hit, the yield to maturity for the S&P/LSTA U.S. Leverage Loan 100 Index -- the benchmark for the Powershares Senior Loan ETF -- was at 6.2%. Today it’s at 4.34%. Even worse is the spread, as the 10-year Treasury rate has risen from around 1.7% in November 2012 to 2.5% recently. So bank loan investors are riding a spread of less than two percentage points today, compared to 4.5 percentage points a few years ago.
Now in the short-term it’s seemingly blue skies for bank loan investors. An improving economy is always nice news for the junky segment of the bond market that turns more on economic activity than interest rate movements. But it’s what comes after -- or in a surprise -- that deserves careful consideration. The PowerShares Senior Loan ETF wasn’t around in 2008 but the benchmark index it tracks lost 29% that year. It’s not a stretch to suggest that many retail investors are being lured by the 4.5% yield without proper appreciation that these are a) junk bonds and b) junk bonds crater like stocks in times of market selloffs.
And the next selloff could be especially painful for bank loan investors. Retail funds and ETFs didn’t exist five and half years ago; by one estimate about one-quarter of the inflows into bank loans are now coming from retail investors. Just imagine what those unsuspecting investors might do when the market sells off. It’s something that big institutional investors are well aware of. In an interview at the Morningstar Investor Conference, Michael Buchanan, head of global credit research at mega bond firm Western Asset Management, noted that while the firm likes bank loans in the short-term, what happens ‘round the bend is concerning.
“What if we did have a dramatic turn, and you saw very aggressive outflows in bank loans and high yield? The dealer community doesn't necessarily have the balance sheets that they did four or five years ago due to regulators' risk management, so there's just not that mechanism to dampen severe outflows, and it shows up immediately in price,” Buchanan told Morningstar. And he made a point that “a very aggressive sell-off” was not out of the question.
Straight up junk spreads are equally concerning. The 3.5 percentage point-or-so spread for the leading junk benchmark is not much reward, and if you’re convincing yourself you’re smart by sticking with the highest quality junk (BB) your spread is barely 2.5 percentage points:
Given the potential downside, that seems like an especially paltry payout. Here’s the total return for both junk indexes during the worst of the late 2008 implosion:
Granted, 2008 may indeed be an outlier in terms of severity, but even if you generously halved those loses, getting paid 4.5% or so in current yield doesn’t seem enticing. Sticking with high quality stocks seems more appealing. Sure, you’re not going to necessarily get 4.5% in yield (unless you’re going to venture into MLPs and REITs) but you can pocket around 3% with solid names like Chevron (CVX), McDonalds (MCD), Coca-Cola (KO), Cisco Systems (CSCO) and General Mills (GIS):
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And if you’ve been hot on bank loan funds for their adjustable rate feature that should deliver higher payouts when rates rise (at least when the LIBOR rises, which is not likely any time soon given the Fed’s stated goal of keeping a clamp on short-term rates for another year), well dividend payers can be pretty impressive on that front. While Cisco only started paying a dividend in the past few years, the other stocks mentioned have been paying-and increasing the payout-at an impressive clip for years:
Carla Fried, a senior contributing editor at ycharts.com, has covered investing for more than 25 years. Her work appears in The New York Times, Bloomberg.com and Money Magazine. She can be reached at email@example.com. Read the RIABiz profile of YCharts. You can also request a demonstration of YCharts Platinum.