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This Senior-Loan ETF Isn’t the Panacea It May Seem

While it offers an attractive yield and limited interest-rate risk, this senior-loan strategy exposes investors to considerable credit and liquidity risk.

Morningstar, 03/24/2017

PowerShares Senior Loan ETF BKLN may offer an attractive yield and low interest-rate risk, but it takes significant credit and liquidity risk in doing so. It provides market-cap-weighted exposure to the 100 largest U.S. floating-rate senior loans, which are among the most liquid in the loan market. But this is still a very illiquid market where active management of liquidity and credit risk offers an advantage over this index strategy. So, despite its attempt to mitigate liquidity risk, the fund earns a Morningstar Analyst Rating of Neutral.

Senior loans have minimal price sensitivity to changing interest rates because their coupon payments float with prevailing interest rates and typically reset once a quarter. These adjustments make the duration of the loans close to zero, limiting the fund’s interest-rate risk.

While its interest-rate risk is low, its credit risk is high. Most of the fund’s assets are invested in below-investment-grade loans. As of February 2017, the average default rate from 2002 to 2017 for high-yield loans was 3.3%, according to JPMorgan and S&P. The minimum initial spread must be 125 basis points over Libor to be included in this fund. Thus, despite its short duration, the fund offered a yield of 2.7% in February 2017.

Senior loans’ illiquidity creates challenges for the fund. There is a liquidity mismatch because the fund must provide daily liquidity, while there is no set time limit to settle senior-loan trades. In fact, it took 17 days on average to complete a senior-loan trade during the second quarter of 2016, per Markit. The fund employs various measures to address the liquidity risk. It allocates roughly 10% of its assets to cash and more-liquid high-yield bonds. The rest of the assets are skewed toward the most-liquid and largest loans. It also has a line of credit for emergency liquidity events.

Even though it has struggled to keep up with the index recently, the fund has tracked its index well through the years. During the trailing five-year period through February 2017, the fund lagged its benchmark by 67 basis points annually. This gap is in line with its annual cost of 0.65%.

Fundamental View 
A senior loan is issued by a non-investment-grade company, and its assets are pledged against the loan. This structure gives the investor a claim on the company assets, providing some protection against defaults. Below-investment-grade companies seek senior loans mainly because they can lower funding costs, customize the financing structure, and keep their sensitive information private.

There is an inherent liquidity risk built in this fund. While it provides daily liquidity, its holdings are thinly traded. For example, senior loans’ average bid-ask spread was 85 basis points as of February 2017, according to LSTA. It can be even more expensive particularly for an index fund like this that demands liquidity. This illiquidity is primarily driven by the private origination and heterogeneous nature of senior loans.

However, the fund takes a few steps to mitigate liquidity risk. First, it maintains around 10% of the portfolio in cash and high-yield bonds that are settled within three days after the transaction. The fund attempts to source high-yield bonds from the same issuers of senior loans in its index where possible. Second, the fund invests in the 100 largest, most-traded senior loans. This focus should help reduce transaction costs, but it also tilts the fund toward the most-indebted issuers. The fund also sources loans from the primary market, which arguably provides better pricing than secondary markets. Third, the managers may request accelerated settlement from their counterparties. Invesco is a large participant in the U.S. senior-loan market, so counterparties have incentives to accommodate these requests. Last, the fund has an emergency line of credit, which allows it to borrow to bridge the gap between the time it takes to receive cash from the sale of its holdings and its obligation to provide daily liquidity to investors.  

This fund takes less credit risk than most of its senior-loan Morningstar Category peers, leading to lower returns. While more than 60% of its assets are in loans issued by non-investment-grade firms, the corresponding figure for the category average is more than 80%. The fund’s five-year annual return through February 2017 of 3.5% was behind the category average of 4.2%. Its Sharpe ratio, a risk-adjusted return metric, ranked in the bottom 10% during the same period. This underperformance was partially attributable to the fund’s cash position. Given the fund’s large cash holdings combined with a less-aggressive credit-risk profile, its risk/return pattern is likely to continue.

Portfolio Construction 
The fund earns a Neutral Process rating because of the liquidity challenges and high transaction costs it faces. Also, its index is not representative of the target market it is trying to capture. Thus, the fund’s performance can deviate from the category average as its peers favor less-liquid and riskier loans. Active management should pay off in this market.

This fund seeks to provide investment results that, before fees and expenses, correspond to the performance of the S&P/LSTA U.S. Leveraged Loan 100 Index. The index is composed of the 100 largest senior loans, weighted by market value. Qualifying loans must be senior-secured, denominated in U.S. dollars, and have a publicly assigned CUSIP. Also, they must have a minimum initial term of one year and minimum initial spread of Libor plus 125 basis points. The minimum par amount is $50 million. Each Friday, S&P reviews the index constituents and reduces the weighting of constituents that exceed 2.0% of the market-value weighting of the index to 1.9%. The index is rebalanced semiannually to avoid excessive turnover. But it is reviewed weekly to reflect pay-downs and ensure that the index portfolio maintains 100 loans. The fund can invest 20% of its capital in securities outside of the index, and it regularly parks some of its assets in cash and high-yield bonds to mitigate liquidity risk. These positions may create some tracking error.

Fees/Costs 
This fund charges 0.65%, which is cheaper than 87% of its peers and supports the Positive Price Pillar rating. The category average fee is 0.86%. The fund’s return has come close to its index over the long term, but the gap between the fund and the index has been widening in recent years. Its five-year annual return through February 2017 of 3.55% was 67 basis points less than the index’s return. However, it posted annual returns during the trailing one- and three-year periods through February 2017 of 10.53% and 2.15%, respectively. They were behind the index by 201 and 79 basis points during the same period. This underperformance can be attributed to a few factors. The market experienced high volatility after the November election, and subsequently the fund experienced an inflow of $2 billion from December 2016 to January 2017. High transaction costs associated with market volatility and the fund’s large cash balance contributed to its underperformance against the index.

Alternatives 
Highland/iBoxx Senior Loan ETF SNLN is a close passively managed alternative that has considerable overlap with BKLN’s holdings. The fund screens for the most-liquid 100 senior loans and weights those by market value to mimic the returns of the Markit iBoxx USD Liquid Leveraged Loan Index. With an expense ratio of 0.55%, it was the cheapest bank-loan exchange-traded fund as of February 2017. Unlike BKLN, it does not hold high-yield bonds.

SPDR Blackstone/GSO Senior Loan ETF SRLN is a comparably priced (0.70% expense ratio) actively managed alternative. The fund is subadvised by Blackstone/GSO, under the leadership of Dan McMullen. The team seeks to uncover mispriced securities through bottom-up credit research. This fund held 7% in bonds and virtually no cash as of March 6, 2017. Although it is slightly more expensive than BKLN, it is a persuasive option for exposure to senior loans.

First Trust Senior Loan ETF FTSL is also actively managed and charges a higher 0.86% expense ratio. The managers perform fundamental credit analysis on loans and tend to make many small bets to reduce the liquidity needs of any single holding. The fund favors companies with stable cash flows, strong management teams, and quality assets.

 

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