JPST - BKLN ETF: High Income And Diversifier But Avoid Due To SVB Financial Contagion Risks

2023-03-10 17:45:43 ET

Summary

• Senior loans are attractive when compared to same-duration bonds while insulating better against stock market volatility in a period of rising rates.
• Additionally, Invesco Senior Loan ETF BKLN provides for relatively higher yields, too.
• However, as exemplified by SVB Financial Group, any woes impacting the banking sector are likely to be contagious to BKLN's senior loans.
• After the dust has settled, investors may consider owning BKLN as part of a diversified portfolio.

In a context where higher interest rates and lower liquidity penalize most asset classes, income seekers who have laid their trust in the Invesco Senior Loan ETF ( BKLN ) have benefited directly. This is evident by its dividend history chart below, which shows that from the beginning of 2022, distributions have been rising rapidly to reach and exceed the $0.1 per month level, with a bonus of over $0.2 in December last year.

This period has coincided with the Federal Reserve tightening monetary policy and hiking interest rates at a pace not seen since the 1980s . However, as this thesis will show, senior loans are not without risks after the SVB Financial Group ( SIVB ) episode. The aim here is basically to show that in this highly uncertain period, it is also important to compare senior loans with other asset classes in terms of opportunities and risks.

Senior Loans Attractiveness

First, BKLN provides investors with exposure to the senior loan markets, which is just another segment of the debt market with other examples being bonds. However, unlike investment grade bonds, senior loans are issued to companies with lower credit ratings or those which are considered as higher risk, but, these are still secured by collaterals such as the company's assets. Moreover, they have a higher priority in terms of repayment compared to other forms of debt such as unsecured bonds.

Pursuing further, one of the benefits of investing in senior loans is their ability to provide higher returns, namely yields when compared to other fixed-income investments. Looking into more details, one of the reasons for this high yield is the maturity of most of BKLN's debt holdings being in the 1-5 years and 5-10 years range, at 57.85% and 42.05% of total assets respectively, as pictured below. These average out to relatively longer-duration debts, for which the issuer charges a higher rate of interest due to the higher risk (as a result of the long period the amount of money is owed) compared to shorter-dated ones.

This is the reason why to compare the dividend yield and price performance, I chose a mixture of long-duration investment-grade, government treasuries, and junk bonds. These are shown in the table below, and are the iShares Trust - iShares Core 5-10 Year USD Bond ETF ( IMTB ), iShares Core 1-5 Year USD Bond ETF ( ISTB ), as well as the iShares Short-Term Corporate Bond ETF ( IGSB ) which holds 1-5 years of investment-grade bonds. I also included the iShares Intermediate-Term Corporate Bond ETF ( IGIB ), which holds 5-10 investment-grade bonds.

The results of the comparison show that, except for HYG's junk bonds, BKLN pays the highest dividend yields, but, on the other hand, has delivered the least degree of underperformance over a period of one-month and one-year, as shown below.

The Risks

Consequently, senior loans offer better yields at less degree of volatility both on a short and long-term basis when compared to other debt instruments. Still, its sub-zero underperformance figures show that BKLN is not completely immune to stock market volatility. In this respect, investors are cautioned that its higher yields are only feasible because of increased risks associated with investing in the senior loan market as the likelihood of the borrower defaulting on the loan is more.

Looking across the fixed income space, for those prepared to opt for lesser yields, there are other investments like treasury yields or short-term investment-grade corporate bonds of the iShares Ultra Short-Term Bond ETF ( ICSH ) and JPMorgan Ultra-Short Income ETF ( JPST ), respectively. These two funds have benefited from less volatility especially, after worries about the financial health of SIVB, a major lender in Silicon Valley for tech startups. Now, the fact that the S&P 500 Financials Sector is down suggests that there are fears among investors that there could be a contagion effect on the wider banking industry, and this does not augur well for the non-investment grade bonds in general.

For this matter, most of BLKN's holdings, or 66% as shown in the right side diagram below are categorized as "B" according to Moody's Rating Scale. This is a non-investment grade according to Moody's scale provided to the left-hand side.

However, to mitigate against those risks, there is fundamental credit research specific to each ETF's holdings, which is of paramount importance because success in the business of bank loans is above all about not losing money.

Risk Mitigation and the Diversification Rationale

In this respect, BKLN provides a diversified portfolio of 126 holdings across a range of industries and sectors as pictured below, with individual weights limited to 2%. This signifies fewer concentration risks and there is also the fact that the underlying fund is managed by Invesco, a leading global asset management firm with a strong track record in the fixed-income market.

Another of its advantages is its low expense ratio of 0.65%, which is lower than the average for similar funds in the senior loan market like the SPDR Blackstone / GSO Senior Loan ETF ( SRLN ) and the First Trust Senior Loan Fund ( FTSL ) while offering better price performance.

There is also portfolio diversification.

In this context, devoting part of your bond portfolio to senior loans can be attractive, both in the short and long term, for the following reasons. First, as seen in the above comparison table, BKLN is uncorrelated to the performance of other debt instruments, which signifies that it can reduce the overall risk in a portfolio. Second, because they are backed by collateral and occupy a senior, secure position in the capital structure, bank loans can reduce the risk investors face in the event of default.

For this purpose, the underlying fund is based on the Morningstar LSTA US Leveraged Loan 100 Index designed to track the market-weighted performance of the largest institutional leveraged loans based on market weightings, spreads, and interest payments. Interestingly, the Fund only purchases 80% of the component securities in the index and also makes use of a "sampling" methodology to seek to achieve its investment objective.

Third, thanks to its mix of variable coupons (fixed income and floating rates loans ), BKLN moderates the interest rate risk. Thus, the floating rate component thus helps the senior bond prices from falling when rates rise, while delivering higher dividend payments as seen in the introductory chart. For investors, most traditional bond securities simply do not offer this double advantage.

Concluding with Caution

Therefore, for income seekers, Invesco Senior Loan ETF could fit into a portfolio of bonds and equities, but, it is advisable to wait for this period of volatility unleashed by contagion risk from SIVB to be over. To provide some assurance to investors, as per Bloomberg, American banks " can contain contagion risk and system stress stemming from the turmoil."

However, a look at the charts and figures below provides a vivid idea of the adverse impact on BKLN's share price due to the fact that senior loans to corporations are generally issued by banks. Thus, the Invesco ETF's shares went down by more than 0.4% on March 9, whereas safer asset classes like ICSH (including treasuries) and JPST (short-term investment-grade corporate bonds) both gained, by 0.26% and 0.04%, respectively.

Finally, compared to other debt instruments, Invesco Senior Loan ETF's senior loans can provide better yields, while providing better protection against market volatility, but any woes impacting the banking sector are contagious to this asset class. This is the reason why it is not the appropriate time to invest.

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