Bond investors must worry about duration risk; how changes of interest rates will effect bond value. Corporate loan investors, typically linked to LIBOR rates resetting frequently, are less concern with duration risk but must deal with less liquid asset and long settlements periods, in the order of 20 days or longer. Wouldn’t be dreamy if you could have the liquidity of bonds but still retain the low duration risk of bank loans? If this proposition raises a sense of “too good to be true”, your intuition would be correct, yet $7 billion of such assets are available in the form of bank loan ETFs such as Senior Loan Portfolio ETF issued by PowerShares.
liquidity magic
By packaging these loans in ETFs, bank loans can be traded intraday while the underlying loans would still be stuck at 20+ days settlement. Has financial ingenuity reach the point of replicating quantum state superposition of liquidity and iliquidity? Looking deeper, one can see there is no shrodinger cat, this apparent liquidity is created by intermediaries arbitrageurs designated as Authorized Participants (AP). As demand for the ETF increases pushing prices above portfolio value, the AP will sell the ETF and buy the underlying loans to lock a profit, conversely on a sell off the AP will buy the ETF at discount and swap for the underlying. This works best for the AP in a sideways market with no dominant buyers/seller but in a rapidly declining market, the settlement effects of the underlying portfolio surfaces making it more tricky for AP to meet redemption requests.
To manage the settlement mismatch AP use various ‘alternative liquidity’ tools such as holding substantial part of the portfolio in cash or more liquid bond, for extreme cases AP can also tap into lines of credit. These so called liquidity alts have not truly been tested yet in the ETF market. BlockRock, the largest maker of ETFs decided not to wait around to find out on the resilience of these workarounds ending the manufacturing of bank loan and leveraged ETFs last year citing ‘structural risks’ in these products.
Until more robust liquidity alternatives are dreamed up, the only reliable solution is to cut this settlement mismatch. In a previous post, it was suggested how arranging banks can use Distributed Ledger technology to address some of the challenges in the corporate syndicated primary market. Connecting primary market participants with APs could not only smooth the primary to secondary flow, but also help reduce this settlement gap.
Resistance to change
While technology can bring this gap to manageable levels, a first barrier to overcome is the disincentive for participants in the primary market to modernize the loan syndication process. Banks benefit from settlement lag as they can collect fees for committing capital while shifting risk to investors. This environment however is unlikely to last if regulators start looking at this settlement mismatch as unaccounted warehoused risk in disguise.
The subprime crises taught us that AAA tranches cannot be extracted out of subprime loan pools,
it might take another crisis to accept that liquidity cannot be generated out of underlying illiquidity