Nadig: Tread Lightly In Bank-Loan ETFs

March 13, 2014

The current rate is about 2 percent. The long-term average has been around 4 percent, and during 2009, defaults ran as high as 11 percent. So, that’s the bad news.

But the (sort of) good news is that while they may have a high risk of default, they have higher-than-normal recovery rates; that’s because they’re senior debt that gets paid first. Check out this great primer on the topic from Vanguard if you want to dig into the math more.

And the floating rate makes defaults trickier to predict.

While an initial run to 1 percent on Libor won’t cost the borrowers any more (or get you, the investor, any more yield), a significant interest-rate spike simply makes it harder and harder for the borrower to make payments, which actually increases the probability of default the higher the rates run.

And last, there’s the demand and liquidity problem. There just isn’t that much floating-rate debt around.

The rush of buyers has driven yields down to 4 percent from more than 6 percent just two years ago. Worse, should there be some sort of crisis in the debt markets, liquidity would likely dry up, driving bond prices and fund net asset values (NAVs) down in a hurry as investors head for the door.

SRLN and BKLN are too new to have been tested in a real crisis, but I’d have some concerns these underlying liquidity issues could show up in the form of discounts as well, adding insult to injury.

Both funds generally trade at a “normal” premium to NAV between 10 and 30 basis points, but we have seen BKLN swing to premiums and discounts based on flows —a sure sign of low liquidity in the underlying holdings.

So where does this leave investors? Hopefully being cautious, and not so hungry for yield they forget about the risks.

At the time this article was written, the author held no positions in the securities mentioned. Contact Dave Nadig at [email protected].

Find your next ETF

Reset All