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Beware of Banks Breaking Bad: Why You Should Think Twice About Bank-Loan ETFs

Bank stocks have always been a key indicator of how confident investors feel. But what if the banks themselves start to wobble? That’s exactly the concern buzzing around in 2024. Experts, especially some top strategists from Bank of America, are waving red flags about the rapid rise of bank-loan ETFs and the hidden risks they might be carrying.

We’ve seen the market cycle through plenty of phases—low rates, high inflation, and now a desperate search for yield. Right now, leveraged loans and “bank-loan” ETFs are grabbing everyone’s attention. These funds promise attractive returns as interest rates rise. Sounds great, right? But as with most shortcuts in finance, there’s usually a catch.

The Appeal of Bank-Loan ETFs

Bank-loan ETFs are supposed to be simple. They gather together senior secured loans—basically loans banks give to companies that don’t quite make the grade for investment-grade bonds. These loans have floating interest rates, meaning the rates adjust with the market, which should help protect investors when rates go up.

On paper, it’s a win: better yields than most bonds, and less risk from rising rates. Plus, these ETFs are easy to buy and sell, which makes them popular with everyday investors. I’ve seen folks jump into these funds especially when headlines warn about bond prices getting hammered if rates keep going up.

But when you dig deeper, things aren’t that neat.

A Word from the Experts

Michael Hartnett, a sharp strategist at Bank of America, has been sounding the alarm. “Banks breaking bad” isn’t just a catchy phrase—it’s a warning. He’s concerned about how fast money is flowing into bank-loan ETFs, and he thinks many investors are underestimating the risks.

The core issue? The loans inside these ETFs aren’t nearly as easy to sell as the ETF shares themselves. When markets are calm, this isn’t a big deal. But when panic strikes and everyone wants out at once, these funds can’t just offload loans quickly. There just aren’t enough buyers out there, so prices can plunge fast.

I’ve seen this scenario before—in the COVID crash and other market hiccups. The ETF shares might trade smoothly, but the underlying loans? Not so much.

Why Bank-Loan ETFs Are a Double-Edged Sword

Let’s be honest: the rush into bank-loan ETFs is mostly about chasing yield, not managing risk carefully. With the Fed’s moves uncertain and traditional bonds under pressure, investors are hungry for alternatives. Leveraged loans look appealing because of their higher yields and floating rates.

But here’s the catch—these loans are to companies with shaky credit. When times are good, defaults stay low, but if the economy slows or rates rise too much, defaults can spike. Being “senior secured” helps protect lenders, but it’s no silver bullet. Recovering money can take time and often disappoint.

Many investors, even professionals, don’t fully grasp how complex these loans are. Just because an ETF shows you a price every day doesn’t mean the risks vanish. If anything, the ETF can hide what’s really going on underneath.

Where This Strategy Can Go Wrong

Two big issues often get overlooked:

• Liquidity dries up fast during a crisis. When everyone wants out, the fund has to sell loans in a market with few buyers. Prices can fall sharply, and you might face losses much bigger than expected.
• The credit risk is real. These loans go to companies that can’t tap traditional bond markets. If things go south economically, defaults rise. Diversification helps, but it doesn’t eliminate the risk of a widespread downturn.

That said, bank-loan ETFs can work well when rates rise slowly or markets stay steady. They can be a useful small part of a portfolio for savvy investors who understand these risks. But relying on them as your main fixed-income holding? That’s playing with fire.

Regulation Could Shake Things Up

Another wildcard is regulation. Authorities keep a close eye on liquidity mismatches in ETFs, especially after market shocks. If the next downturn triggers forced selling and losses for retail investors, expect regulators to step in with new rules that could change the game for these funds.

Lessons We’ve Learned from Past Crises

Every time a new investment product promises high returns with low risk, it reminds me of 2008 with subprime mortgages, or 2023 when some private credit funds froze withdrawals. The pattern is clear: liquidity and safety get assumed, until suddenly they aren’t.

Stress tests often miss scenarios the market hasn’t faced before. So when reality hits, it can get ugly fast.

What Should You Do?

The best advice? Approach bank-loan ETFs with caution. They’re not bad, but they’re not as simple as they look. Keep your exposure modest and don’t count on being able to sell quickly if things turn sour.

Diversify your fixed income holdings and pair these ETFs with higher-quality bonds to balance risk. And always think about your worst-case scenario—what happens if the market crashes or defaults spike? Many investors don’t spend enough time on this question.

When Things Go Wrong

If you need to sell during a panic, you could face painful losses. If defaults rise, expect the value of these funds to drop. And if regulators clamp down after a crisis, you might find yourself locked in longer than you planned.

Final Takeaway

Bank-loan ETFs are tempting in today’s hunt for yield. They offer some real benefits when conditions are right, but they’re far from a magic fix. As the Bank of America strategist warns, the risks here are real and often underestimated.

I’ve seen too many investors learn the hard way that liquidity and credit risk bite when you least expect it. So before jumping in, ask yourself: are you ready for banks breaking bad? If not, sometimes the smartest move is to stay on the sidelines and avoid the next scramble for the exits.

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