By Timothy Strauts
PowerShares Senior Loan Portfolio (BKLN) is a satellite holding for investors who are comfortable with assuming greater credit risk (its portfolio securities' average credit rating is BB) and that may be looking for floating-rate bonds to protect against rising interest rates. Most investors' portfolios are dominated by fixed-rate bonds. The biggest risk that fixed-rate securities face is the potential for rising interest rates. An easy way to minimize this risk is to diversify a bond portfolio with floating-rate securities. While few expect rates to rise dramatically in the near term, it pays to be prepared. If you wait for rates to rise before protecting yourself, it may be too late when the time comes.
What Are Bank Loans?
Bank loans are denoted high-yield for the sole reason that the firms issuing them are highly leveraged. Companies with this kind of leverage profile can get there either intentionally (because of a leveraged buyout, leveraged acquisition, or recapitalization) or unintentionally (because of a deterioration of the underlying business of an erstwhile investment-grade firm). Either way, the risk from leverage is the same, even if the businesses may be moving in different directions. With increased leverage comes the increased probability of default and bankruptcy.
Senior floating-rate bank loans are variable-rate, senior secured debt instruments issued by non-investment-grade companies. Bank loans have a variable rate that adjusts every 30 to 90 days. The duration of a bank-loan fund is near zero because of the regular adjustment of interest rates. This rate is a fixed-percentage spread over a floating base rate--typically the London Interbank Offered Rate, or Libor. Bank loans are the most senior security in the capital structure. They are secured by collateral such as equipment, real estate, or accounts receivable. Bank loans are considered safer than traditional high-yield bonds because this secured collateral protects the investor in the event of a default.
Most investors typically become interested in bank loans when interest rates are expected to rise. With the Federal Reserve committed to maintaining low rates for "at least as long" as the unemployment rate remains above 6.5%, current investor apathy towards bank loans shouldn't come as a surprise. But with yields in the high-yield-bond sector near historic lows, bank-loan funds are looking more attractive on a relative basis.
IShares iBoxx $ High Yield Corporate Bond (HYG) has a current SEC yield of 5.32%. For comparison, BKLN, which tracks the 100 most-liquid bank loans, has a SEC yield of 4.80%. By sacrificing 52 basis points of yield you get a portfolio of bank loans, which are--as we explained earlier--relatively safer investments than traditional fixed-rate high-yield bonds. Bank loans have historically had a lower average default rate of only 3% compared with high yield's average default rate of 4.75%. Because all bank loans are senior secured bonds, in the event of a default they also have a relatively high average recovery rate of 65%. Traditional high yield is dominated by senior unsecured bonds, which have a historical average recovery rate of only 44%. If defaults--or more importantly interest rates--rise, bank loans would be the better choice of the two for more-conservative investors.
In a rising-rate environment, bank loans tend to outperform fixed-rate securities. Of course, investors en masse are aware of this, which is why retail asset flows for the sector increase during these periods. What is not as well understood is that, in a flat-rate environment, bank loans also outperform the broad bond benchmark. The main reason explaining this outperformance is the yield advantage that the bank loans provide over the Barclays Aggregate Bond index. In today's market, the Barclays index has a current yield to maturity of around 1.5%, which gives BKLN a 3.3% yield advantage. If we stay in the current flat-yield environment, bank loans look very attractive.
Perhaps the largest risk to bank loans is the potential for a U.S. recession in the near future. While this is not expected by the majority of surveyed economists, the impending fiscal cliff could push the United States into a recession if Congress doesn't come to a compromise on future tax rates. A recession would increase defaults for the bank-loan sector, which would depress the prices of loans. However, we wouldn't see this as a reason to panic. Morningstar has been tracking the bank-loan sector since 1989, and the available data shows that bank loans typically have positive performance even during recessions. The only year that bank loans posted a negative return in this time frame was 2008, when they lost 29%.
Much of that loss was due to the over-issuance of new loans in the wake of the leveraged buyout boom of 2006 and 2007. Many companies used the bank-loan market as their preferred source of financing, especially those engaged in leveraged buyouts. By their nature, LBO firms employ large amounts of debt, and when Lehman Brothers went under in September 2008, fear spread through the market, pushing loan values to historically low levels. To make matters worse, many buyers of bank loans were highly leveraged themselves and had to dump loans on the market to meet margin calls. Amidst the panic, bank loans became very illiquid and new issuance ground to a halt.
It appears as though the market has learned its lesson from the financial crisis because current bank loans are being issued with a conservative risk profile that is more typical of that seen in the period before 2006. The highly leveraged hedge fund investors who drove much of the market volatility have not returned in large numbers. While a recession would hurt returns, the bank-loan market appears better prepared for a downturn today than it was in 2008.
BKLN seeks to provide investment results that, before fees and expenses, correspond generally to the price and yield performance of the S&P/LSTA U.S. Leveraged Loan 100 Index. The index is composed of the 100 largest loans in the bank-loan universe. Loans in the index must be senior secured first-lien loans, have a minimum maturity of one year, have a minimum spread of 125 basis points above Libor, and have greater than $50 million par amount outstanding. Its focus on the largest loans should improve the overall liquidity of BKLN. T
he fund currently has 129 holdings and uses sampling to mimic the results of the underlying index. The average credit quality of the underlying holdings is BB, and the average maturity is 4.5 years. The current distribution yield is 4.4%.
Because the bank-loan market can become illiquid, the ETF has special liquidity provisions. First, because of the unique nature of bank loans and the specialized trading desk required to transact loans, BKLN will take creations and redemptions in cash instead of the traditional in-kind method. This means that the fund is responsible for buying and selling loans in the fund. Also, the fund may borrow through an existing credit line in response to adverse market conditions. Borrowings are limited to 33 1/3% of the fund's total assets. If BKLN uses this provision, the fund will become leveraged similar to a closed-end fund.
Finally, the fund can hold up to 20% of its portfolio in bank-loan CEFs. In the event of a market panic, the portfolio manager has the ability to choose between using the credit line, selling individual loans, or selling CEFs. This increased flexibility should improve overall liquidity of the ETF.
This fund charges a 0.76% fee. While this is still quite a bit higher than what investors would pay for an aggregate bond index, it is cheaper than many actively managed bank-loan funds. While individual bank loans can sometimes be illiquid, this ETF has good overall market liquidity with more than $1 billion in assets and average trading volume over 200,000 shares per day.
There are no direct competitors to BKLN currently. Investors looking for high-yield debt should consider HYG (0.50% expenses), SPDR Barclays High Yield Bond (JNK) (0.40%), or PowerShares Fundamental High Yield Corporate (PHB) (0.50%).
Closed-end funds are ideal vehicles for investing in illiquid markets because of their fixed-capital base. Eaton Vance Floating-Rate Income Fund (EFT) is the highest-rated closed-end bank-loan fund by Morningstar analysts. EFT has an experienced management team, and it has beat the peer group and index over three- and five-year annualized periods, while keeping fees in check.
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