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Interest rates are going to rise. It isn't a matter of if, but when. Rising rates can cause severe headaches for fixed income investors. As interest rates rise, bond yields rise, pushing bond prices down. This is especially problematic for investors who own bond funds or do not hold their bonds to maturity.

This problem has caused many investors to seek alternatives that still provide a relatively fixed rate of return but also offer some protection from rising rates. The ETF industry has been happy to oblige, offering up numerous products intended to weather the rising rate environment.

One such new ETF is the PowerShares Senior Loan Portfolio (BKLN). This fund seeks to track the investment performance and yield of an index called the S&P/LSTA U.S. Leveraged Loan 100 Index. The fund invests in senior loans, or floating rate loans, issued by a bank or financial institution to a company (usually below investment grade). These loans are usually contractually senior to any other debt or equity and are secured by collateral such as property, inventory, equipment, etc. The appeal of senior loans in a rising rate environment is that they are normally floating rate loans, meaning they are set at a predetermined spread over LIBOR.

The PowerShares website offers some insight in how senior loans (measured by the index) are correlated to other fixed income investments. For example senior loans have a -.40 correlation to the Barclays Capital U.S. Government Intermediate index. This means that senior loans have more of a negative correlation to this index (moving opposite directions). Since intermediate term government bonds would be negatively affected by rising rates, this may be positive for investors. In another example senior loans (measured by the index) have a .42 correlation to the consumer price index, meaning that as the CPI moves higher the senior loan portfolio tends to move higher as well (a perfect correlation would be 1.0).

BKLN invests at least 80% of its assets in senior loans that make up the index. 20% of the assets may be invested in closed end funds that invest in senior loans or other liquid securities.

Top Ten Holdings as of 4/14/11

Name Coupon Rate Weight
ING Prime Rate Trust 0.00% 3.04%
First Trust Senior Floating 0.00% 3.04%
Eaton Vance Senior Income Trust 0.00% 2.62%
Texas Competitive Electric Holdings 10/10/14 3.78% 2.59%
Tribune Company 6/04/14 2.27% 2.47%
SunGuard Data Systems Inc. 02/26/16 3.93% 2.18%
First Data Corporation 09/24/14 3.00% 2.15%
Univision Communications Inc. 03/31/17 4.50% 1.97%
Cengage Learning Holdings II, L.P. 2.50% 1.97%
CIT Group Inc. 08/11/15 6.25% 1.93%

BKLN was launched on March 3, 2011. Since inception the fund is up 0.72%. The fund traded ex-dividend for the first time on April 15th. The current yield is 3.5% and the fund will pay distributions monthly. The fund has an expense ratio of 0.83%.

Obviously senior loans carry a higher default risk than investment grade bonds. Investors will have to determine how much extra risk they want to assume for protection against higher rates. One disadvantage to this fund is that it is not actively managed. This type of fund may perform better under active management rather than index tracking. The expense ratio is relatively high for an index fund. Eaton Vance offers an actively managed closed end fund, Eaton Vance Senior Floating Rate Trust (EFR), which has a higher distribution yield, at 7%. The expense ratio for EFR is 1.22%. The problem with EFR is that it currently trades at a 5% premium to NAV.

I like the prospects for BKLN in a rising rate environment. I certainly believe we will see higher rates in 2012. I also like that BKLN pays monthly distributions, maximizing reinvestment opportunity. Investors will have to decide whether to invest in a product such as BKLN or another alternative. One thing is for sure: I don't want to be invested in most bond funds in a rising rate environment.

Source: PowerShares Senior Loan Portfolio ETF Offers Yield and Rising Rate Protection