How to Get More Than 4%, While Protecting Against Principal Loss

By
A A A

Investors have been trying to get higher rates of returns for years now, while at the same time worrying about capital loss in their fixed income securities if and when interest rates start climbing up, which they at some point will. Money has poured into bond funds. In 2012, high-yield bond funds added substantial amounts of new money, and emerging markets bond funds did also. One segment of the fixed income market that did not receive much in the way of new assets is the bank loan debt funds. Bank loan debt funds attracted very little in new assets in 2012.

As investors look for higher rates of return while also wanting to hedge against principal loss, they should know about the advantages of senior bank loan securities, and that these types of securities are available in an ETF. Senior floating-rate bank loans are senior secured debt instruments that are issued with variable rates by non-investment-grade companies. The rate on senior bank loans reset every 30 to 90 days. The rate is a fixed-percentage spread over a floating base rate, usually the London Interbank Offered Rate (Libor). Bank loans are considered the most senior security in the capital structure universe because bank loans are secured by collateral of the company making the loan. A company could pledge as collateral its assets such as its equipment, its real estate, or its accounts receivable. Bank loans are similar to high-yield debt but could be considered safer because the secured collateral gives the investor a level of protection in case of a loan default.

In a rising-rate environment, bank loans tend to outperform fixed-rate securities. Of course, investors 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 for the outperformance is the yield advantage that the bank loans provide over the Barclays index. In today's market, the Barclays index has a current yield to maturity of only 2.5%, which gives the bank-loan index a yield advantage. If we stay in the current flat-yield environment, bank loans look very attractive.

Risks

One of the biggest risks to bank loans is the potential for a US recession in the near future. While a recession is not expected by the Federal Reserve and many economists, factors such as the ongoing political war over taxes and spending 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, some data show that bank loans have positive performance even during recessions. The only year that bank loans posted a negative return in a recession was 2008, when the bank loan sector lost 29%. Much of that loss was due to the issuance of loans in the leveraged buyout boom of 2006 and 2007. Current bank loans are being issued with a conservative risk profile, one that is more typical of the period before 2006. The highly leveraged investors who drove much of the market volatility have not returned. While a recession will hurt, the bank-loan market looks better prepared today and may even post positive returns in the next recession.

ETF Investment Option

The PowerShares Senior Loan Portfolio (NYSEARCA:BKLN) tracks the S&P/LSTA US Leveraged Loan 100 Index, which is designed to track the 100 largest bank loans. The focus on the largest loans will increase liquidity of the portfolio. Because the bank-loan market can become illiquid, the ETF has special liquidity provisions. Because of the nature of bank loans and the specialized trading required to transact loans, BKLN will take creations and redemptions in cash instead of the traditional in-kind method. Also, the fund may borrow through an existing credit line in response to adverse market conditions. If BKLN uses this provision, the fund will become leveraged similar to a closed-end fund. In the event of excess volatility in the market, the portfolio manager has the ability to choose between using the credit line and selling individual loans. This increased flexibility should improve overall liquidity of the ETF. BKLN currently pays a 30-day SEC yield of about 4.20%.

RevenueShares Is Adding an Emerging Market ETF

In many cases, investors have run out of patience with emerging markets. Many have been told to invest in these market for the long term, but emerging market ETFs have had disappointing performances relative to US stocks. More patience is required as developed countries' ETFs keep improving relative to emerging markets ETFs.

There are signs that later in 2013 and in 2014 investors will be rewarded for holding emerging markets. These markets are cheap on a valuation basis, and the longer their economies stay stable, instead of collapsing as many pundits are predicting, the better the chances this sector will snap back on the upside.

One ETF that should be considered is the soon-to-be-released emerging markets offering from RevenueShares. RevenueShares weights known equity indexes by revenues instead of the weights used by the original indexes, which are usually cap weighted. RevenueShares weights each company in the index by its trailing fourth-quarter revenue, and rebalances the index on a quarterly basis. The performance of the RevenueShares ETFs have been impressive, validating for RevenueShares their belief that top line revenues is the most important fundamental factor in determining a company's net worth.

RevenueShares' new ETF will replicate the Bank of New York Mellon Emerging Markets 50 ADR Index (INDEXDJX:BKTEM) and will use the companies listed in that index. The countries comprising the largest share of the index are Brazil, China, Mexico, Taiwan, South Korea, and India. The largest sector exposure is energy, financial services, communication services, technology, and basic materials. Of course, the countries, sectors, and other components in the Bank of New York index will be different in the RevenueShares ETF, since the underlying index will be weighted by the RevenueShares methodology instead of the Bank of New York index cap- weighting construction.

Editor's Note: Max Isaacman is the author of Blizzard of Money , Winning with ETF Strategies , Investing with Intelligent ETFs , How to Be an Index Investor , and The NASDAQ Investor.




The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , ETFs

Referenced Stocks: BKLN

Minyanville

Minyanville

More from Minyanville:

Related Videos

Stocks

Referenced

Most Active by Volume

89,070,840
  • $17.26 ▲ 3.23%
78,931,485
  • $7.02 ▲ 4.46%
77,555,734
  • $6.70 ▲ 6.69%
77,025,346
  • $24.66 ▲ 0.69%
74,713,335
  • $101.80 ▲ 1.82%
72,324,726
  • $7.64 ▲ 0.79%
57,112,188
  • $17.84 ▲ 55.27%
53,321,397
  • $18.01 ▼ 4.46%
As of 12/17/2014, 04:15 PM


Find a Credit Card

Select a credit card product by:
Select an offer:
Search
Data Provided by BankRate.com