BKLN: Leveraged Loan ETF With An Implicit Inflation Hedge

Sep. 23, 2021 10:06 AM ETInvesco Senior Loan ETF (BKLN)1 Like
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Summary

  • BKLN is a leveraged loan ETF with a 2.73% SEC yield.
  • Middle of the road Sharpe ratio of 0.42 with a very low standard deviation of 4.81.
  • While drawdowns have been very shallow (sub 10% loss), the trailing 3- and 5-year total returns are mediocre at 2.7% and 3.1%, respectively.
  • Fundamentally, the leveraged loan market is very strong with issuer leverage continuing to decline and interest coverage ratios going up.
  • SOFR has not yet been fully adopted by the loan market, with the Libor replacement rate eventually resulting in forecasted lower all-in yields.

Leveraged Loan is shown on the conceptual business photo
Andrii Dodonov/iStock via Getty Images

Thesis

The Invesco Senior Loan ETF (NYSEARCA:BKLN) is one of the largest leveraged loan ETFs in the market. With a Sharpe ratio of 0.42, it provides access to one of the least volatile corners of the sub-investment grade market. The fund has a 2.73% 30-day SEC yield with a quasi-zero duration given the floating rate nature of the leveraged loan asset class. From a fundamental perspective, the leveraged loan market has been improving steadily, with issuer leverage ratios coming down and interest coverage improving. The fund has had very shallow drawdowns but has also posted mediocre 3- and 5-year trailing total returns. I am assigning BKLN a "Hold" rating for current investors looking for an asset class with an implicit inflation hedge and lack of negative impact from the Fed tapering. I also have a "Buy Under" accumulation target of $21.25/share for new investors looking to enter the ETF. Investors looking for higher yields from the leveraged loan asset class should consider CEFs in this space. Institutional investors such as hedge funds and private equity funds have access to leverage via bank TRS structures in order to increase their returns from this low volatility market. Retail investors have CEFs at their disposal.

ETF Metrics

This section details some ETF metrics and overall fund analytics:

Leverage Ratio: 0%

  • No additional structure leverage.

Expense Ratio: 0.65%

  • On the high side compared with other ETFs.
  • Represents ~24% of the 30-day SEC yield the fund pays.

Manager: Invesco

  • Premier asset manager with a solid track record.

Yield: 2.73% SEC Yield (3.2% 12 months trailing yield)

  • This is the best metric when analyzing a short duration loan fund given the current low interest rate environment.
  • The 30-day SEC yield gives you an accurate snapshot of what cash you are actually going to receive based on where the portfolio currently is.

Source: Author

Libor vs SOFR

One less known aspect for retail investors in respect to leveraged loans is the tentative transition away from Libor and into SOFR. Libor (London Interbank Offer Rate) is a rate that was tainted by manipulation and fixing that came to light post the great financial crisis of 2008-2009. The regulators set about to create more transparent floating rates, hence the genesis of SOFR (Secured Overnight Financing Rate). The leveraged loan market has been extremely slow in terms of transitioning from Libor into SOFR and the reason for that is a lack of term structure for SOFR. The main differences between the two rates are as follows:Source: pensford.com

One very important aspect to keep in mind as an investor into the leveraged loan market is that SOFR is usually lower than Libor, because it is a secured rate. Below you will find a graph from Reuters outlining the difference between the 2 rates during 2019:

Source: Reuters

For an investor into the leveraged loan market SOFR means a lower rate paid to you, hence a lower yield. This market transformation will eventually happen and ultimately will result in overall lower all-in yields for BKLN.

Portfolio Composition - Credit Risk

Source: Invesco

The fund is composed almost entirely of leveraged loans, with a normalized distribution around the BB bucket. This is a middle of the road credit allocation, with the riskiest type of debt (CCC bucket) exhibiting a low number.

Source: Invesco

The vast majority of issuers are from the US, meaning they are subject to the jurisdictional and legal requirements of US courts and any restructurings would very likely go through a Chapter 11 filing and the requisite protection that offers to senior secured loan holders.

The fund does not make additional disclosures around senior secured 1st lien or covenant light percentages, although these are important aspects for the underlying credit quality of a portfolio.

Similarly, we do not have an industry concentration statistic to gauge if there are any pockets where the fund is taking too much risk. The only other credit-related aggregation that Invesco discloses is around the top 10 issuers:

Source: Invesco

However, from a macro perspective, defaults in the leveraged loan space are expected to continue to be very low:

Source: KDP

Portfolio Composition - Market Risk

In this section, I will discuss in more detail the aspects of the BKLN portfolio that relate to market risk - i.e. fluctuations in risk-free rates and credit spreads that can cause upward or downward pressure on the BKLN portfolio NAV.

Given the floating nature of the underlying leveraged loans, the fund basically has a duration very close to zero. This means that the price of the loans and the NAV of BKLN will not be affected negatively by a rise in interest rates as the Fed starts tapering asset purchases and starts raising interest rates.

The main risk in this fund is the credit spread risk. As we can see from the below graph, underlying leveraged loans credit spreads are at historical lows:

Source: KDPAM

As we have seen in prior risk-off instances, as the market sells off, credit spreads widen and we see a drawdown in BKLN. Given we are starting from a very low base here (historically tight spreads), one can argue there is more downside than upside.

Returns

Source: Author

To note that the fund did not lose money in 2013 when interest rates went up (2-year T-Note yield was up more than 100bps) as opposed to many competing HY bond funds. The reason for that is the floating rate nature of the underlying assets.

The fund lost money in 2015 and 2018 when credit spreads blew up during a market-wide sell-off:

2015 - oil prices collapsed towards the end of the year, with credit spreads in both the bond and loan market widening substantially

2018 - Nov/Dec of that year saw a market-wide sell-off on the back of recessionary concerns

The fund generally has a positive performance, being dragged into negative territory by market-wide events only. However, trailing returns are fairly mediocre when accounting for the fact that you are investing in a below investment grade instrument.

Conclusion

Coming from a premier asset manager, BKLN invests in a portfolio of leveraged loans. From a fundamental perspective, the leveraged loan market has been improving steadily, with issuer leverage ratios coming down and interest coverage improving. Forecasted market default rates are also expected to be extremely low. Even though BKLN has a decent Sharpe ratio of 0.42 and low standard deviation of 4.81, it sports an extremely low SEC yield of 2.73% for a below investment grade asset class. The fund has posted mediocre trailing 3- and 5-year returns (2.7% and 3.1% respectively) but has exhibited very low volatility as measured by its standard deviation. I rate it as a "Hold" for current investors looking for an asset class with an implicit inflation hedge and have a "Buy Under" accumulation target of $21.25/share for new investors looking to enter the ETF.

This article was written by

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With a financial services cash and derivatives trading background, Binary Tree Analytics aims to provide transparency and analytics in respect to capital markets instruments and trades._____________________________http://www.BinaryTreeAnalytics.com
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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