A Bond Fund That Stands Up to Rising Rates

John Gabriel: Bank loans, also called leveraged or floating-rate loans, are a unique offering within the high-yield fixed-income complex. In recent years, bank loans have come into focus as many investors look to protect their bond portfolios from an eventual rise in interest rates.

The most popular ETF in the category is PowerShares Senior Loan ETF (BKLN), which provides passive exposure to a market-weighted benchmark of 100 of the largest loan facilities in the U.S. leveraged-loan market. 

The fund can play a valuable supporting role within a broader bond allocation, but investors should make sure to approach the asset class with realistic expectations.

BKLN's impressive string of performance coming out of the financial crisis can be mostly attributed to normalizing credit spreads. After plunging nearly 30% in 2008 amid the financial crisis when credit markets froze and liquidity for bank loans dried up, BKLN's portfolio traded at around $0.60 on the dollar. So, recovering loan prices in the ensuing years provided a significant tailwind for performance.

The picture today is much different. Amid stronger investor demand, liquidity has returned to the market and new issuances have reached record highs. To put the potential for capital gains into context, consider that, as of May 19, 74% of BKLN's portfolio traded above par value. On an asset-weighted basis, the fund's portfolio now trades at an average of $0.98 on the dollar.

As a result, there is little to no room for price appreciation, given that bank loans are callable at par at any time. So, returns going forward will, therefore, be driven almost exclusively by the coupon payments.