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