Nadig: Tread Lightly In Bank-Loan ETFs

March 13, 2014

Bank-loan funds are worth a look, but make sure it’s a close look.

There are a lot of headlines about the dangers of bank-loan funds and the investor rush. But let’s separate fact from fiction.

The PowerShares Senior Loan Portfolio (BKLN | B) and the SPDR Blackstone / GSO Senior Loan ETF (SRLN | B) have been hot tickets lately. BKLN has pulled in nearly $1 billion this year already.

It’s easy to understand why. There are two sources of risk in bonds that investors are compensated for with yield. The first is duration risk—you get paid more to loan someone money for a long time than overnight. The second is credit risk—you get paid more to loan money to my crazy Uncle Ivan than you do to Warren Buffett. Most bond investments are a blend of the two sources of risk.

On one end of the spectrum you have Treasurys, which effectively remove all of the credit risk. So the various maturities, from overnight to 30 years, are “pure” duration compensation.

And at the other end, you have floating-rate debt issued to shaky companies. That’s what these ETFs invest in. Because the notes being held by the funds are reset every 90 days, generally, the idea is that you’re getting pure exposure to the credit side of the risk, but not taking on very much duration risk. You expect your coupon payments to go up when interest rates rise.

If you’re going to invest in junk bonds for yield, the theory goes, why not get some protection from the Fed along the way?

It’s a good theory, but there are some rather enormous caveats.

The first is that a lot of these loans don’t actually just march in lock step with Libor.

Most have a floor—usually 1 percent right now—that Libor has to pass before any adjustments happen. With three-month Libor hovering around 0.25 percent right now, that’s a rather enormous interest-rate hike you need to see before you get one penny more yield than the 4 percent you’re getting today on the average bank loan in these portfolios.

The second caveat is that you can kind of kiss your understanding of “credit risk” goodbye.

The companies issuing floating-rate debt here are rated anywhere from B to C to “unrated” (shudder).

Both funds have a heavy concentration in the middle of the range, which is to say, BB and B rated. That in itself doesn’t seem all that junky. By comparison, the SPDR Barclays High Yield ETF (JNK | B-61) has most of its portfolio in bonds rated B and lower.

But default rates on bank loans swing all over the place.

 

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