By Timothy Strauts
PowerShares Senior Loan Portfolio (
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 (
) 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
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
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 (
) (0.40%), or PowerShares Fundamental High Yield Corporate (
Closed-end funds are ideal vehicles for investing in illiquid
markets because of their fixed-capital base. Eaton Vance
Floating-Rate Income Fund (
) 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.
Morningstar, Inc. licenses its indexes to institutions for a
variety of reasons, including the creation of investment products
and the benchmarking of existing products. When licensing indexes
for the creation or benchmarking of investment products,
Morningstar receives fees that are mainly based on fund assets
under management. As of Sept. 30, 2012, AlphaPro Management,
BlackRock Asset Management, First Asset, First Trust, Invesco,
Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or
more Morningstar indexes for this purpose. These investment
products are not sponsored, issued, marketed, or sold by
Morningstar. Morningstar does not make any representation regarding
the advisability of investing in any investment product based on or
benchmarked against a Morningstar index.
Why Chevron Is The Best Supermajor Oil Company