Bank Loan ETFs May Be Good Investments, But Beware of Liquidity Risks

Hidden Risks Ahead

 

There are good reasons why investors should take a long hard look at Senior Bank Loans as a fixed income investment choice in an environment where interest rates are certain to rise.

  1. Most if not all senior loans are structured with floating rates, so that as interest rates rise, the coupon they pay will rise also.
  2. Senior bank loans are exactly where the name implies they lie on the capital structure of a company. They are usually the most senior claim after accounts payable.
  3. The correlation of senior bank loans to other fixed income securities tends to be low. This may be because of the lack of an exchange trading mechanism that adjust price continuously, but the fact of the matter is that correlations are low.
  4. Because the borrower is rated below investment grade, in most cases, the coupon paid on these loans tends to be higher than on comparable floating rate, higher credit quality bonds.
  5. These loans tend to be short-term in nature, so in addition to the higher coupon rates and floating rate nature that minimizes duration risk, the short-term maturities may make it easier to evaluate the credit risk of the company issuing the loan.

But as an individual investor, you may find it difficult to invest directly in bank loans. They are not traded on an exchange so you can’t really enter an order in your Ameritrade account. So the options available are to invest in them through either mutual funds or ETFs.

What to Watch out for in Bank Loan ETFs and Mutual Funds

There are arguments in the financial media for both advantages and disadvantages of bank loan ETF’s. The advantages include low cost exposure, diversification, and liquidity. While some of the disadvantages are lack of fundamental analysis (passive investing) and a mismatch between the liquidity of the bank loans and that of the ETF.

Trade settlement on bank loans can take as long as two to three weeks while ETF’s can be redeemed daily. This creates a risky mismatch in the event of a sudden outflow of funds caused by investor panic attacks. (Not too uncommon) In the event that redemptions occur at a faster rate than positions can be liquidated, investors may not receive less than the value of the portfolio.

The largest bank loan ETF is the PowerShares Senior Loan Portfolio (BKLN) with almost $7 billion in AUM, mimics an index, The S&P LSTA US Leveraged Loan 100 Index. This index is designed to reflect the performance of the largest facilities in the leveraged loan market, not necessarily the most attractive based on fundamental metrics, but probably the most liquid. So investors choosing to invest in BKLN may have less risk of a liquidity mismatch but not necessarily the best bank loan funds.

Finally, despite being heralded as good hedges against rising interest rates, most bank loans have a LIBOR floor. With LIBOR hovering at such low levels, the initial reaction of coupons on bank loans may be somewhat muted until LIBOR surpasses the floor at which interest rates begin to adjust. For example, if bank loans have a coupon of LIBOR+5% with a LIBOR floor of 0.75%, the loan will never have a coupon of less than 5.75%. However, if LIBOR is at 0.25%, it would take a 50bps increase before the coupon on the bank loans will be adjusted.

Conclusion

Investors still interested in investing in bank loans should do their due diligence on the available options and consider several key features of each investment:

  • liquidity matching – no bank loan fund will have perfect liquidity matching with the underlying securities unless it offers monthly liquidity. Look for as little variance as possible.
  • Active vs. passive management – its quite possible that the importance of active management is no higher than it is in the bank loan space. These are risky securities and passive investing may not necessarily reflect the best possible investments in the space for a given level of risk.
  • Fund size – a larger fund is not necessarily better than a smaller fund. At some point, a fund may be so big, it may not be able to find adequate buyers at reasonable prices when trying to sell positions. Is the PowerShares fund at $7 billion too big. Only a stress scenario will reveal that, so proceed at your own risk.

Bank loans can be a great diversifier to a well balanced portfolio and will certainly complement other types of fixed income investments. But like any other investment, the returns come at the peril of certain risks. Know these risks before investing.

CBL & Associates: A Detailed Look At The Transformation Reveals A Potentially Sharp Upside Move

CBL and Associates

Uncertainty is the enemy of investing. When there is any uncertainty around the predictability of a company and its earnings, ‘smart investors’, or so they are called, tend to stay away. You could argue that this approach is a smart approach; after all, preservation of capital is the most important prerequisite of growing capital. But investing involves risks and while avoiding them will certainly result in capital preservation, it will not lead to attractive absolute returns. After all, if you don’t take risk, you should expect to earn the risk-free rate. That rate, as measured by the 10-year Treasury, is currently about 2.5%. Some may argue that this return wouldn’t even cover the rate of inflation.

Annaly Adjusts Portfolio Drivers As Visibility Improves

Annaly Capital Management

Back in April, I wrote an article on Annaly (NLY) where I expressed my opinion that Annaly is a sleep well at night investment, if invested in correctly. (Read Article) I have to admit that this was probably not the most accurate way for me to express my opinion about Annaly. You see, my philosophy is more focused on overall returns on a portfolio and that if you have a portfolio of sleep well at night investments then it is likely your returns will not be much better than the risk-free rate. Everyone knows that, right? It is investing 101, or if I can throw in a shameless plug, portfolio management 101. In fact, if investing in a portfolio that was only generating the risk-free rate for a long period of time, I could wake up from my slumber realizing that the value of my portfolio has barely kept up with inflation, if at all.

I Wish They All Could be California REITs

ROIC Logo

Have you ever ordered anything from Amazon? It sure beats having to drive in traffic to get to the mall or shopping center; only to spend another 15 minutes looking for a parking space; then wasting precious time looking for the one item you went in there to buy, never mind that you now have a cart full of ‘things’ you weren’t even looking for; then search the entire store hoping to find someone that can help you locate said item; only to find someone stocking aisle 15, whom when asked where you could find your item, monotonically responds: “I don’t know where anything is outside of aisle 15”; to then stand in the express lane (10 items or less) watching a woman unload 37 items and 79 coupons; who then pays with a check; while asking for cigarettes that the cashier has to get from the front desk; to finally get back to your car to notice a ding on the driver side door; and because you’ve been at the store all day, are now sitting in afternoon rush hour traffic to get back home.

Alternative Mutual Funds Under Investigation by SEC, but Don’t Panic

SEC Investigating Alternative Mutual Funds

Alternative mutual funds are under investigation by the SEC, but there is no reason to panic and certainly no reason to sell your positions in these funds. The SEC SHOULD be looking into the space and quite honestly, its about time. Many alternative mutual funds use complicated strategies usually only offered by hedge fund managers and only available to qualified investors. (The definition of qualified investor is another point of contention I won’t get into here). These alternative mutual funds, like their distance cousin hedge funds aren’t for everyone. The fact that they are so easily bought now is reason enough for the SEC to look into them further.

Cohen & Steers: The King Of REITs Poised To Provide Investors 42% Annualized Returns

Cohen & Steers: King of REITs

Retail investors are increasingly looking for ways to further diversify their portfolios to avoid a repeat of 2008-2009, where they saw both equity and fixed income holdings decline concurrently. One asset class that has received plenty of attention and is expected to grow five-fold in 6 years is the Retail Liquid Alternative (RLA) space, where Cohen & Steers (CNS) is well positioned as the pioneer in real estate related securities. With its strategic initiative to expand into other retail liquid alternatives and well developed distribution channels, CNS stock can grow 8x in our base case scenario.