Author’s note: This article was released to members of the CEF/ETF Income Laboratory on January 22, 2022.
The Invesco Senior Loan ETF (BKLN) is an index-based ETF focused on floating rate senior secured loans from lower quality companies. It offers investors a relatively low dividend yield of 3.1%, but because the fund’s holdings are indexed to market interest rates, dividends are expected to rise as interest rates rise, while share prices remain stable. Senior loans are one of the only asset classes to have performed relatively well in recent weeks and should continue to perform well under current market conditions. BKLN is a buy, and particularly appropriate for income investors concerned about rising interest rates and equity valuations.
Floating Rate Bond Comparison and Investment Thesis
BKLN invests in floating rate loans. They are fixed income securities that have several important differences from more traditional fixed rate bonds. Understanding these differences is key to understanding BKLN, so let’s focus on those first.
Fixed rate bonds pay a fixed interest rate payment throughout their term. Market conditions may change, but the interest rate on the bonds remains the same.
Floating rate bonds pay a floating coupon throughout their term, usually LIBOR, which closely tracks the federal funds rate set by the Federal Reserve, plus a spread. As central bank rates rise, interest payments on bonds also rise, and therefore shareholder returns. Lower rates have the opposite effect.
As is clear from the above, fixed rate bonds and floating rate bonds react very differently to higher interest rates. Let’s analyze this in more detail with a simple example.
You have two bonds with the same characteristics: the price, the interest rate, the duration and the maturity are identical, but one is fixed and the other floating.
Bonds could look like this:
In the example above, both bonds are yielding 1%, and these are the returns shareholders can expect from investing in either bond.
Suppose the Federal Reserve raises rates by 1.0% because some analysts expect is likely to occur throughout the year.
Floating rate bonds are expected to see their coupons increase by 1%, or $10, leading to higher returns and dividends for shareholders.
Fixed rate bonds should not see any changes in their coupons, they are fixed after all.
The links might now look like this:
As can be seen above, the floating rate note has benefited from rising interest rates and now offers higher coupons and higher returns to shareholders. Investors will soon notice that this is the case and will sell their low yielding fixed rate bonds to buy higher yielding floating rate bonds. Fixed rate bonds should see their prices fall accordingly. It is important to note that fixed rate bond investors receive the full $1,000 they originally invested once the bonds mature, regardless of the price of the bond: lower prices are only a temporary loss. Investors will sell fixed rate bonds until their expected returns equal those of floating rate bonds. Prices would decline by about $10, the difference between the two bonds’ coupon payments.
Bonds might end up looking like this.
At these prices, the yields of the two bonds are about the same. Floating rate bond investors receive a coupon of $20. Fixed-rate bond investors receive a $10 coupon and should see $10 in capital gains once their bond matures (they buy the bond for $990, but receive $1,000 at maturity).
The increase in federal funds rates led to higher coupon rate payments, dividends and floating rate bond yields.
Rising federal funds rates resulted in a short-term capital loss for the fixed-rate bond.
The increase in the federal funds rate was a plus for the variable rate bond, a negative effect for the fixed rate bond. Considering the near certainty Fed funds rate hikes over the next few months, floating rate bonds seem like a no-brainer. With that in mind, let’s take a look at BKLN.
BKLN is a floating rate loan index ETF. It tracks the S&P/LSTA US Leveraged Loan 100 Index, an index of senior secured loans, the largest type of variable rate obligation. BKLN’s holdings have several important characteristics.
BKLN’s holdings are all senior secure loans. Senior means that these loans are a company’s highest financial obligation and must be paid in full before the company makes payments on other loans, bonds, or even dividend payments. Secured means that these loans are secured by durable assets of the business. In the event of the company’s inability to meet its financial obligations, investors receive these durable assets, allowing them to recover (partially) their investment. For this reason, senior secured loans are relatively safe securities, at least relative to equities or high yield corporate bonds.
BKLN’s holdings are generally relatively low quality securities with low credit ratings and high default rates. The fund’s average holdings have a credit rating of B, an incredibly low credit rating, and indicate companies with weak balance sheets and finances.
Focusing on low-quality securities increases risk, while focusing on high-quality secured securities reduces risk. The result is a moderately risky fund, somewhere between that of an investment-grade bond fund and an equity fund. Expect moderate losses during downturns and recessions, as was the case in 1Q2020.
BKLN’s holdings are almost all variable rate loans, as almost all senior secured loans have variable rates. There are exceptions, these two titles are not identical, but these are rare. According to the fund’s latest annual report, about 96% of its non-cash holdings were floating-rate loans, with the rest fixed-rate loans. As the vast majority of BKLN’s holdings have floating rates, we can characterize the fund as a floating rate fund, with all the advantages that entails. BKLN is expected to outperform its peers when rates rise, as it has for several periods in the recent past. For example, rates have been rising since December 2021, with the 10-year treasury bill rate increasing by around 0.35%.
BKLN has outperformed its peers since December 2021, as expected.
BKLN should also see higher dividend payments when the Federal Reserve increases rates later in the year, although it may take a few months for these increases to trickle down to shareholders. For example, the Federal Reserve last raised rates between 2017 and 2019.
BKLN’s dividends have seen some growth, as expected. Growth, however, has been uneven, volatile and somewhat dependent on the specific period analyzed.
By comparison, the iShares iBoxx $High Yield Corporate Bond ETF (HYG), a high yield corporate bond index ETF, saw its dividends decline over the same period.
BKLN’s dividends are doing better in a rising rate environment than HYG’s, as expected.
Finally, and on a more negative note, BKLN is currently reporting a paltry 3.1%. This is a relatively low return on an absolute basis and the lowest return in the fund’s history. It is slightly above the average for a bond fund, but below that of most high-yield corporate bond funds. As mentioned earlier, BKLN should see higher dividends as the Federal Reserve raises rates, but that hasn’t happened yet and the fund’s current dividends are quite low.
Finally, BKLN currently has an expense ratio of 0.65%. Expenses are relatively high, and a bit higher than average for a broad index ETF. BKLN’s high expense ratio directly reduces the fund’s dividend yield and total shareholder return, and is a significant negative for the fund and its shareholders. I’m generally wary of investing in expensive index funds, but there aren’t many options available in this particular niche, and the fund has one significant advantage. Let’s look.
BKLN Investment Thesis
BKLN’s entire investment thesis hinges on the fund’s relatively strong performance when interest rates rise, as they are currently in short supply. Very few asset classes and funds can reliably work well when interest rates rise, especially when coinciding with bearish market sentiment, as has been the case since the start of the year. Senior secured loans are one of the only asset classes that haven’t posted losses since the start of the year, with most stocks, bonds and even safe-haven assets like treasury bills being falling.
BKLN is likely to outperform most broad-based asset class index funds as long as interest rates rise and economic conditions remain bearish. This is a significant benefit for the fund, and particularly important for investors concerned about current economic conditions, particularly rising interest rates. As mentioned earlier, there are simply few funds and asset classes that perform well when BKLN does, so the fund could potentially be one of the top performers if current conditions hold.
Conclusion – Buy
BKLN invests in senior secured loans, which are expected to generate higher yields and stable stock prices as interest rates continue to rise. BKLN should benefit from current economic trends, outperforming most of its peers. The fund is a buy, and particularly suitable for investors concerned about rising interest rates and difficult market conditions.