Nadig: Tread Lightly In Bank-Loan ETFs

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.

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].