PowerShares announced today the launch of the Senior Loan Portfolio (BKLN), the first ETF offering exposure to a corner of the credit market known for low sensitivity to interest rate changes. BKLN will seek to replicate the S&P/LSTA U.S. Leveraged Loan 100 Index, a benchmark designed to track the market-weighted performance of the largest institutional leveraged loans based on market weightings, spreads and interest payments. The underlying index is drawn from the larger S&P/LSTA Leveraged Loan Index, which includes more than 1,100 facilities.
Senior Loans 101
Senior loans, also known as leveraged loans, syndicated loans, bank loans, or floating rate loans, are debt instruments that are issued by a financial institution and syndicated through a group of banks and institutional investors. Generally senior loans are extended to companies with a credit rating below investment grade, and are often issued in conjunction with leveraged buyouts or other M&A activities. As the name suggests, senior loans are usually senior to other obligations of a company, and in many cases are secured by physical collateral.
The key difference between senior loans and many other non-investment grade debt securities relates to the interest rate risk. Senior loans are generally floating rate debt, meaning that the applicable interest rate will be calculated as a pre-determined spread over a reference rate. That rate is usually the U.S. dollar London Interbank Offered Rate (LIBOR), the rate at which banks borrow unsecured funds from other banks in the London wholesale money market [see Market Vectors Planning Investment Grade Floating Rate Bond ETF].
Recently, the three-month LIBOR rate was hovering around 30 basis points. So if a senior loan paid LIBOR + 500 basis points, that security would now be yielding about 5.3%. Loans eligible for inclusion in the index underlying BKLN must have a minimum initial spread of 125 basis points over LIBOR at the time of issuance.
At launch, the yield to maturity of BKLN was just under 5%, and the portfolio had an average of about 33 days until reset of the interest rate. The majority of the 77 underlying holdings are rated BB or below, and about 58% of the portfolio matures in the next five years.
Uses For BKLN
Because the effective interest rate moves in lockstep with prevailing market rates, the senior loans held by BKLN won’t be significantly impacted by interest rate hikes. Generally increases to interest rates lead to a decline in value of fixed rate debt, since the relative attractiveness of the payments made by existing debt is diminished by expectations of higher-yielding securities going forward [see all the ETFs in the High Yield Bond ETFdb Category].
So BKLN essentially isolates the credit component of the fixed income risk profile–the risk that the issuers will be unable to fulfill their obligations to creditors. As such, BKLN can be thought of as the opposite of the Barclays 20-Year Treasury Bond Fund (TLT) that offers exposure to long-dated Treasuries. The interest rate risk of BKLN is minimal thanks to the float feature, while credit risk (and therefore, the associated yield) exists given the nature of the underlying issuers. TLT, on the other hand, has plenty of interest rate risk–the effective duration is north of 15 years–but minimal credit risk (assuming, of course, that the U.S. government won’t default on its obligations to bondholders).
So BKLN has value as a diversifying agent within the credit allocation of a fixed income portfolio, and may be appealing for investors concerned about the impact of rising interest rates on their bond holdings. After Fed Chairman Bernanke stressed that the central bank is prepared to fight higher commodity prices if inflationary pressures begin to have a negative impact on U.S. growth, some investors have accelerated projections for changes to record low interest rate hikes.
Historically, senior loan benchmarks have exhibited very low correlations to other types of fixed income securities, highlighting the potential appeal of an asset class with limited sensitivity to interest rates:
|Credit Suisse Leveraged Loan Index|
|Barclays Capital U.S. Government Intermediate||-0.40||-0.90|
|Barclays Capital U.S. Aggregate||-0.04||-0.08|
|Barclays Capital U.S. Municipal Bond||0.27||0.43|
|BofA Merrill Lynch U.S. Corporate Master||0.37||0.45|
|Barclays Capital U.S. Treasury (TIPS)||0.17||0.19|
BKLN is the first U.S.-listed ETF to offer exposure to senior loans, a somewhat puzzling void in the space considering that there are dozens of mutual funds offering exposure to these securities. One such product comes from PowerShares parent Invesco; the Van Kampen Senior Loan Fund (VSLAX) is benchmarked against the S&P/LSTA Leveraged Loan Index. That fund gained about 12% last year, and at the end of 2010 had a 30-day SEC yield in the neighborhood of 5% [try the Mutual Fund To ETF Converter].
BKLN will charge an expense ratio of 0.83%, putting it above many of the other funds in the High Yield Bonds ETFdb Category. The average for that category is 0.55%, with options as low as 40 basis points [see PHB: A Different Kind Of Junk Bond ETF].
Disclosure: No positions at time of writing.