- The dividend yield for BKLN has tightened, while the credit quality of the underlying assets - leveraged loans - has deteriorated.
- BKLN holders may not realize that most leveraged loans will provide protection from rising interest rates with a lag.
- The reach for yield has enabled riskier borrowers to tap the loan market, and recent fund flows suggest a potential change in sentiment for the loan market.
In the Fed-enforced yield-starved world of the past several years, PowerShares Senior Loan Portfolio (NYSEARCA:BKLN) has grown substantially as more investors have flocked to this ETF that holds debt with high yields. BKLN has grown to $6.72 billion as of January 31, 2014 from $225.7 million as of January 31, 2012. The specific attraction of BKLN is based on its investments in leveraged loans, a subset of the high-yield market. Leveraged loans are secured debt rated less than investment-grade, where the borrowers pay floating rate coupons. The high-yield debt market in general has benefited since 2009 from the Federal Reserve's policy of maintaining low interest rates and forcing investors to reach for yield further down on the credit quality spectrum. But there are dangers lurking in this quest for yield in risky assets. And investors who believe that the floating rate coupons of leveraged loans will provide some protection when the Fed finally starts to raise interest rates in the future should be aware of particular features in loan agreements that will delay the increase in coupons that the borrower pays.
Retail investors who have bought this ETF for what appears to be a good dividend yield on the surface should be mindful of the potential sell-off that could hit in the future. BKLN started paying dividends in April 2011. This ETF's first 12 dividends paid, from April 2011 to March 2012, amounted to a total of $1.108, or a dividend yield of 4.48%, based on BKLN price of $24.73 on March 30, 2012. The latest 12 dividends, from May 2013 to April 2014, amounted to $1.027, or a yield of 4.13%, based on BKLN price of $24.84 on May 8, 2014.
The dividend yield has tightened 35 basis points, although the credit quality of the leveraged loan market has eroded over time:
1) S&P, the rating agency, published an article in February 2014 about the leveraged loan market. This article makes several key observations. One is that debt leverage is trending up, which signals worsening credit quality. Another is that S&P saw a growing volume of loans issued to fund dividends to borrowers' equity owners. Although the article mentions that default rates are expected to stay low, these warning flags are indicative of deterioration in credit quality. In other words, the Fed's low interest rate policy has helped riskier borrowers take advantage of the leveraged loan market's hunger for yield.
2) An earlier S&P article, published in January 2014, also highlights the declining credit quality of leveraged loans. The article points out that loan agreements and covenant-light structures have evolved to benefit the borrowers at the expense of holders of these loans. A covenant-light loan agreement only provides the most basic protections for the holder of the loan. In fact, these covenant-light loan deals represented 45% of outstanding loan amounts in 2013, up from 30% in 2012. Covenant-light loan volume in 2013 of about $250 billion far exceeds the amounts issued in the past 10 years.
3) In December 2013, Moody's published a report on Collateralized Loan Obligations (CLOs) that mentions the loan market's trend of financing riskier borrowers. Specifically, the percentage of borrowers who are rated at the lowest end of Moody's rating scale has been growing (see pages 3-4 of the Moody's Report).
When the Fed starts raising interest rates, the reach for yield may be less pronounced, leading to a sell-off in the high-yield bond and leveraged loan markets. Admittedly, it does not appear that the Fed will be raising rates until 2015, but BKLN holders should not be lulled into a false sense of security, as a change in sentiment in the leveraged loan market could precede the Fed's moves and lead to substantial selling pressure. Indeed, the sentiment may be starting to turn. After posting 95 consecutive weeks of inflows into leveraged loan funds, the loan market saw 3 consecutive weeks of outflows (including a whopping $664 million in one week), with a small inflow this week.
Another issue that BKLN holders should be aware of is that there will be a lag in the benefit of owning floating rate debt when interest rates start to rise. Loans carry coupons that are based on Libor plus some additional rate. Since we have been in a low interest rate environment for several years, and 3-month Libor is currently around 22 bps, loan agreements have been structured with a Libor floor. For example, the loan agreement may set the borrower's coupon at Libor + 2.5%, but will stipulate that a minimum (or floor) of 1% must be used for Libor. So, another way to look at this floor is until Libor exceeds 1%, the holder of the loan will be receiving a fixed rate of 3.5%. Thus, interest rates may start rising, but until Libor moves exceed the particular floor set in the loan agreement, the holder will not receive a higher coupon.
Lastly, BKLN invests at least 80% of its assets in the loans that comprise the S&P/LSTA US Leveraged Loan 100 Index. This index consists of the largest, and typically most liquid (in terms of trading volume), leveraged loans. Since the loan market is primarily a dealer market and does not have the same depth of the equity market or corporate bond market, any dislocation could lead investors to sell the most liquid loans first.
So while institutional accounts may be using BKLN as part of a trading strategy, retail investors who are holding BKLN for the dividend yield should consider selling before the market price comes under pressure.