(Bloomberg) -- It was all high-fives and slaps on the back for Mark Okada and his team at Highland Capital Management as they rang the Nasdaq closing bell last week in New York.
No wonder. Okada and Highland were celebrating the best year yet for their ETF, Highland/iBoxx Senior Loan ETF, a $465 million basket of corporate leveraged loans that has returned 7.2% in 2016. They aren’t the only ones smiling; similar ETFs and mutual funds attracted $2.5 billion last quarter. That’s the most in 2 1/2 years, and the wind is still blowing in their favor.
Demand has increased as investors seek alternatives to more than $10 trillion of debt globally that’s yielding less than zero. Loans are different because their yields are tied to the rate at which banks lend to each other, and new regulations have driven this benchmark to its highest level since 2009. To yield-starved investors, that looks like a cash cow.
“Loans represent the best risk-adjusted returns in all of credit,” said Krishna Memani, the New York-based chief investment officer at OppenheimerFunds, which oversees about $223 billion.
Loan ETFs give investors exposure to an array of leveraged companies, some of them deep in junk territory. Highland’s portfolio, which competes with products from Invesco and State Street, holds debt from about 100 borrowers, including Burger King, Weight Watchers International, Valeant Pharmaceuticals International and distressed radio-station operator IHeartMedia.
Loan ETFs and mutual funds netted $415 million in the week ending Oct. 12, the 11th straight week of inflows, according to Lipper U.S. Fund Flows data. That’s due in part to changes in the $2.7 trillion money-market industry that made the funds potentially less secure for investors, spurring capital flight. It also pushed up short-term borrowing costs for banks and corporations. The three-month dollar London interbank offered rate, the benchmark for most commercial loans, has surged above 88 basis points, surpassing the height of Europe’s sovereign debt crisis.
“The spark has finally happened,” said Dave Mazza, the New York-based head of exchange-traded and mutual-fund research at State Street Global Advisors, adding that investors focused on short-term yields will need to recalibrate. “They’ll likely move from prime to government funds for their true cash alternative, but now they have an exposure gap that they’ll need to make up on the yield side.”
Loans are one of the few remaining sources for that yield. Junk bonds have already rallied almost 17% this year but are showing signs of fatigue. Loan ETF returns range from 5.6% to 7.7% this year, data compiled by Bloomberg show, and if something goes wrong, investors are more likely to get their money back, said Jeff Bakalar, co-group head of Voya Investment Management’s senior loan team.
“When compared with high-yield bonds, loans have a much higher recovery upon default, so on this type of risk-adjusted basis, we believe they offer more value,” said Bakalar, whose team manages about $21 billion. “Yield is very scarce globally and it’s making the loan asset class look attractive.”
That holds for the mom-and-pop investors, who own about half the $2.4 trillion U.S. ETF market. The retail appetite has elicited concern from regulators over whether buyers fully understand “more complex and higher risk” products, such as loan ETFs. More than 80% of the leveraged debt owned by Highland’s ETF is rated junk by S&P Global Ratings, and loans can take longer to settle than bonds, which can complicate shareholder redemptions.
Okada, Highland’s co-founder and chief investment officer, said access is one of the key advantages of the Dallas-based company’s ETF. At least 25% is held by those with less than $100 million under management, regulatory filings suggest.
“We’re very happy to bring the fund here, to bring it to Nasdaq, to bring SNLN in so that my mum and dad can invest in what we do,” said Okada, 54, referring to Highland’s ETF by its exchange ticker at its bell-ringing ceremony last week. “It’s a great way to get access to some of the greatest institutional trades that normally they couldn’t.”
Highland’s fund added $160 million of assets this year, data compiled by Bloomberg show. Invesco’s PowerShares Senior Loan Portfolio leads inflows among similar ETFs, attracting $2.1 billion.
With the U.S. Federal Reserve set to raise rates in coming months, those flows show little sign of reversing. Libor typically moves in step with interest-rate increases, meaning when the Fed raises rates, Libor is likely to climb even higher. That could spur further flows into loans and products backed by them, said Jim Fitzpatrick, who manages a loan portfolio at CQS, an asset manager with $12 billion of assets.
“Pension funds are looking how they can claw back some of the funding gaps from low yields,” he said. “If you want corporate exposure, loans are the logical place.”