A Cautionary Tale On Bank Loan ETFs

U.S. interest rates are moving higher, but investors are still searching for income-generating assets. A popular avenue for income investors looking to cope with rising rates has been bank loans or senior loans — an asset class made increasingly accessible by exchange-traded funds such as the PowerShares Senior Loan Portfolio BKLN.

Floating rate notes and senior loans are unique in that their yield is tied to a benchmark such as LIBOR, rather than being fixed. Loans are also higher on the capital structure than other unsecured obligations, and some even carry floors to insure you earn a respectable yield even if rates stay low. Their coupon rate typically resets every 90 days, resulting in a duration shorter than three months, Benzinga reported.

Investor Strategy

So, one way of looking at an ETF such as BKLN, which is passively managed and the largest of the senior loan ETFs in the United States, is that allows income to investors to have their cake and eat it, too. BKLN, which tracks the S&P/LSTA U.S. Leveraged Loan 100 Index, reduces rate risk and has a 30-Day SEC yield of 2.72 percent. That is a nice level of income to get to lower rate risk.

Still, that does not mean BKLN and senior loans are free lunches.

“While its interest-rate risk is low, its credit risk is high. Most of the fund’s assets are invested in below-investment-grade loans,” said Morningstar in a recent note. “As of February 2017, the average default rate from 2002 to 2017 for high-yield loans was 3.3 percent, according to JPMorgan and S&P. The minimum initial spread must be 125 basis points over Libor to be included in this fund. Thus, despite its short duration, the fund offered a yield of 2.7 percent in February 2017.”

Addressing Familiar Concerns

A familiar critique of high-yield bond funds is that they could be vulnerable in liquidity events. While that notion has met with some well-founded opposition as it pertains to traditional junk bond ETFs, liquidity concerns linger for senior loans.

“Senior loans’ illiquidity creates challenges for the fund. There is a liquidity mismatch because the fund must provide daily liquidity, while there is no set time limit to settle senior-loan trades. In fact, it took 17 days on average to complete a senior-loan trade during the second quarter of 2016, per Markit,” said Morningstar. “The fund employs various measures to address the liquidity risk. It allocates roughly 10 percent of its assets to cash and more-liquid high-yield bonds. The rest of the assets are skewed toward the most-liquid and largest loans. It also has a line of credit for emergency liquidity events.”

Still, investors have added $4.8 billion to BKLN over the past year, more than double the inflows to the second-place PowerShares ETF.

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