Senior Bank Loans

As you read in “THE TALE OF THE TAPE(WORM)” Ben Bernanke’s inauspicious use of the word “tapering” on May 2^nd shook world financial markets with a weeks-long bout of heightened volatility – much of it to the downside. In particular, bonds and interest-rate sensitive securities took a significant beating.  For example, the yield on the benchmark 10-year U.S. Treasury Note zoomed upward by over 25% in just 3 weeks – moving from 1.66% to over 2.25%!

Just to remind you of some of the most stark performance figures, take a look at these numbers:

a)    Morningstar reported that the Long-term Treasury Index fell 6.8% in May.
b)    iShares FTSE NAREIT Mortgage Plus Cap Index (REM) fell 12.3% in May
c)    The biggest mutual fund, Pimco Total Return (PTTAX) declined 1.9%, the largest fall since September of 2008!
d)    Any fund using leverage performed worse, such as the Pimco Income Opportunity (PKO) closed-end fund – which fell over 12.6% from high to low in May, and has continued its fall in June (now down over 18% since May 1). (It is invested in a mix of MBS and corporate bonds, along with other bond asset classes and significant borrowing).

Hundreds of thousands of investors (and a whole lot of hedge funds) were caught very flat-footed by this calamitous “messaging change” by the Federal Reserve.  In addition to domestic markets, markets around the world were impacted (since the Fed drives money in the world’s largest economy and most active and liquid financial markets).  In particular, emerging market stocks and bonds were shaken, as were bonds and stocks in Japan – where volatility reached levels bordering upon the absurd. The financial press kept asking (as did I): “What happened to — ‘We won’t let rates rise until unemployment moves down to 6.5% or signs of sustainable inflation in excess of 2% begin to manifest themselves”?

In this shaky financial environment, where should you put your hard-earned funds? If you want to garner a decent return without exposing yourself to unacceptable risk, we’ve already offered a few alternatives for your consideration in past posts here.  Now I will provide you several additional opportunities from which to choose – all of them from the asset class referred to as “Senior Bank Loans”.

Senior Loans are private debt instruments that banks issue as a source of new capital for companies that (typically) have a credit rating below “investment grade”.  As a consequence, the securities backing these loans offer a higher yield in order to motivate investors to accept their higher risk. An additional “kicker” in this asset class has enticed investors into making these securities among the hottest investments currently available. That kicker is that they bear a “floating rate”, thereby providing some relief from interest rate risk. During these first five months of 2013 (including the tumultuous period of May) investors have piled into senior bank loan ETFs looking for a decent return at a reasonable risk.

The biggest senior loan ETF is the PowerShares Senior Loan Portfolio (BKLN) – holding over $3 billion in assets ($1.6 billion has flowed in during 2013, according to data from IndexUniverse).  BKLN has a yield to maturity of 5.69% and an expense ratio of 0.66%.  The Highland/iBoxx Senior Loan ETF (SNLN) launched just eight months ago. It holds $60.5 million in assets, reports a yield to maturity of 5.45%, and has an expense ratio of 0.55%.

Both BKLN and SNLN follow their own leveraged loan index – so they are “passively” managed. That is what prompted State Street Global Advisors to develop an actively managed senior bank loan fund in cooperation with GSO Capital Partners LP (the global credit arm of Blackstone Group (BX)). This fund is so new that it was first listed in early April of this year: SPDR Blackstone/GSO Senior Loan ETF (SRLN). The investment target for the ETF is to outperform the Markit iBoxx USD Liquid Leveraged Loan Index and the S&P/LSTA U.S. Leveraged Loan 100 Index (the very indices that guide SNLN and BKLN respectively).  Therefore, SRLN’s benchmark and commitment is simply to outperform both BKLN and SNLN. The intention of SRLN’s managers is to be more selective on both credit selection and volatility management than a passive fund can be – with the result that, on a risk-adjusted basis, it will boast a higher return!

Since SRLN is still so young, fund metrics are largely meaningless. The ETF will need to develop a track record before it can be recommended with any confidence.

Here is a chart of the price activity of BKLN and SNLN during the full 8-month existence of SNLN:

GRAPH: the chart to the left shows BKLN in blue and SNLN in red. Note that the relative performance of the two ETFs is comparable, with BKLN getting a slight edge.  (Source: YahooFinance.com)

To help offer you a helpful comparison between the two different categories of “floating rate” ETFs, here is a chart comparing BKLN with FLRN (one of the Floating Rate ETFs described in an earlier blog post):

GRAPH: above is a chart comparing BKLN (blue) with FLRN (green).  Note that BKLN shows generally better price performance – except for the period since mid-May (ie. Bernanke’s “tapering”).  See below for an explanation.

Comparing BKLN and FLRN is a bit tricky. Recall that FLRN has an effective duration of 0.12 years (44 days) and a 30-day SEC yield of 0.48%.  BKLN (on the other hand) has a “Years to Maturity” of 4.41 years – which sounds like “forever” when compared with 44 days!  However, the pleasant complication is that the interest rate on BKLN securities “reset” (on average) every 42.5 days! That relatively rapid “reset” serves to significantly reduce BKLN’s exposure to interest rate risk. However, BKLN is obviously perceived as riskier than FLRN because it is composed of loans to “leveraged” companies, and therefore bears a higher credit risk.  That explains the relative outperformance of FLRN versus BKLN during May and June.

Compensating investors for this credit risk is BKLN’s hefty 30-day SEC Yield of 5.29% — besting FLRN by over a factor of ten! In addition, these senior bank loans, although leveraged and bearing a commensurately higher yield, are considerably superior to the U.S. high yield bond market. The average high yield bond is rated B, while the average bank loan is rated BB. More significantly, high yield bonds report just a 30% “recovery rate” on defaulted bonds – while bank loans enjoy a 70% recovery rate on the small 3% (on average) of their bonds that default.

With the caveat that I am neither omniscient nor inerrant, I suspect that this past month’s reaction to Bernanke’s “tapering” remark has been overblown and overdone. It is in the nation’s best interest, the economy’s best interest, and Ben Bernanke’s best interest for him to use his appearance on June 19^th to clarify, in detail, the Fed’s commitment to supply (more than) ample liquidity to the economy (and the markets). As he makes his best attempt to calm the markets, income sensitive securities should begin a recovery period of some sort.  Assuming my scenario proves correct, an investment in BKLN would certainly be both prescient and profitable.

[Disclosure: the author owns BKLN and has owned SNLN. Months ago he skewed a major portion of his interest rate risk toward senior bank loans and one actively managed high-yield bond ETF (HYLD).]

Submitted by Thomas Petty

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