BKLN - FLBL: Cheapest Senior Loan ETF Growing 8.0% Yield

2023-09-19 10:46:44 ET

Summary

• Senior loan funds offer investors strong, growing dividends.
• These funds tend to be relatively expensive too, with the exception of Franklin Senior Loan ETF.
• An overview of the fund follows.

I've covered several senior loan exchange-traded funds, or ETFs, in the recent past. Although I've generally been bullish, I've also been apprehensive about their high expense ratios, with the benchmark Invesco Senior Loan ETF ( BKLN ) sporting a 0.65% expense ratio. Most other senior loan ETFs are even more expensive. The Franklin Senior Loan ETF ( FLBL ) is one of the few exceptions, with a comparatively low 0.45% expense ratio, lowest in its peer group.

FLBL's strong, growing 8.0% dividend yield, low interest rate risk, and comparatively low 0.45% expense ratio make the fund a buy.

Senior Loans and FLBL Overview

A quick primer on senior loans, before tackling FLBL itself. Feel free to skip this section if you already know all about these securities, or if you've read my previous articles on them.

Senior loans are senior to other debt and secured by company assets.

Senior loans are almost always variable rate loans, indexed to specific benchmark rates, and so see higher coupon rates when interest rates rise. Most are indexed to SOFR, a benchmark interest rate which closely tracks the federal funds rate.

Rates are reset at specific intervals, generally quarterly.

So, simplifying things a bit, we can say that senior loans see higher coupon rates when the Federal Reserve hikes rates. This differs from most bonds, most of which have fixed rates of interest from issuance to maturity.

FLBL is an actively-managed ETF focusing on senior loans, with these accounting for around 90% of the fund's asset as per its latest annual report. Short-term bonds and cash account for the remaining 10%. As the fund focuses so strongly on senior loans, it shares more or less the same characteristics as said asset class.

FLBL - Benefits and Investment Thesis

Strong, Growing 8.0% Dividend Yield

Franklin Senior Loan ETF's most important benefit is its strong, growing 8.0% dividend yield. Said yield is quite strong on an absolute basis, and higher than that of most bonds and bond sub-asset classes. FLBL yields quite a bit more than benchmark high-yield bond ETFs, too, even though these have comparable credit risk.

FLBL's dividends have seen very strong growth in the recent past, due to past Federal Reserve hikes. Further growth is likely, but contingent on future Fed policy.

ETF dividends are almost always fully covered by underlying generation of income, and FLBL's dividends are no exception. FLBL generated 9.1% in annualized income last month, as per its SEC yield, and distributed 8.0% to shareholders last year. This implies a covered dividend, although the time periods are obviously different. FLBL generated $14.3M in net investment income last year, and distributed $13.8M to shareholders, so dividends were more than fully covered last year . Conditions could have changed these past few months, but dividends do seem to be covered.

As the fund seems to be generating more in income than it distributes to shareholders, dividends could very easily see further growth in the coming months. Much depends on how economic and industry conditions evolve, however.

FLBL's strong, growing 8.0% yield is a significant benefit for the fund and its shareholders.

On another note, FLBL's dividends seem slightly higher than those of its peers. There is some volatility in these figures, however. The fund yielded more or less the same as its peers close to two weeks ago, when I first published this article on our investment group site.

Very Low Interest Rate Risk

FLBL focuses on senior loans, securities with negligible duration and rate risk, with smaller investments in short-term bonds, securities with low rate risk. The end result is a fund with very low interest rate risk, sporting a duration of only 0.15 years. It is a very low figure on an absolute basis, and lower than that of most bonds and bond sub-asset classes.

Low duration means low interest rate exposure, minimizing losses during hiking cycles. FLBL itself has outperformed since early 2022, when the Fed started to hike, as expected.

Low rate risk decreases portfolio risk and volatility, a straightforward benefit for the fund and its investors. As the Fed has paused / slowed down its hiking, this is unlikely to bring any tangible short-term benefit to investors, but it remains an important long-term benefit.

Although I was unable to find duration data for FLBL's senior loan peers, their duration should be extremely similar, as senior loans invariably have negligible duration. FLBL has outperformed the benchmark BKLN since early 2022, when the Fed started to hike. Outperformance is almost entirely due to strong returns since June, however, and does not seem to have been due to lower duration. FLBL has significantly outperformed SRLN, however.

Below-Average Expense Ratio

FLBL's strong dividends and low interest rate risk are both important benefits, but also relatively common ones, shared by most senior loan ETFs. FLBL does compare favorably to its senior loan peers in one key way: expenses. The fund currently sports a 0.45% expense ratio, somewhat lower than that of its peers, including some of the smaller ones.

Lower expense ratios directly increase (reduce by less) total returns, a straightforward benefit for investors. Focusing on cheaper, less expensive funds is one of the only surefire ways to increase returns. Dividends are easily cut and capital gains might fail to appear, but lower expenses always positively impact investors.

FLBL's below-average expense ratio should lead to comparatively strong long-term total returns. The fund has outperformed most of its peers since inception, in-line with expectations. It did underperform the Virtus Seix Senior Loan ETF ( SEIX ), for unclear reasons, but not by a lot.

FLBL's below-average expense ratio is a small, but impactful, benefit for shareholders, and the fund's key advantage relative to peers.

FLBL - Risks and Downside

High Credit Risk

FLBL focuses on senior loans, which are almost always issued by relatively risky, non-investment grade issuers. The fund itself invests upwards of 90% of its portfolio in said issuers, with a tiny 2% allocation to investment-grade, and 6% in cash.

FLBL's risky holdings should see sizable losses during downturns and recessions, as was the case in 1Q2020, the onset of the coronavirus pandemic. Losses were higher than those of most bonds and bond sub-asset classes, slightly lower than those of high-yield bonds.

From what I've seen, FLBL's current portfolio is a bit riskier than those of its senior loan peers. On the other hand, the fund actually slightly outperformed said peers during the pandemic, contrary to expectations.

The discrepancy above is probably due to portfolio turnover.

Underperformance When Rates are Cut

Senior loans see swift reductions to their coupon rates when rates are cut, leading to underperformance during the same. This was the case from 2020-2021, the last time the Fed cut rates, although T-bills did underperform during said time period (rates were simply too low).

Considering the above, it seems clear that Fed rate cuts would almost certainly lead to swift dividend cuts and lower returns for FLBL. Depending on the magnitude of any potential rate cuts, fund dividends could decrease to very low levels, leading to underperformance and weak total returns.

Right now, senior loans yield around 2.7% more than high-yield bonds, and 5.4% more than their own long-term average. In my opinion, under these conditions, rate cuts would have to be very significant for senior loan yields to drop to below-average levels, and for senior loans to underperform. At least assuming no other significant market movement or change in conditions.

Conclusion

Franklin Senior Loan ETF's strong, growing 8.0% dividend yield, low interest rate risk, and comparatively low 0.45% expense ratio, make the fund a buy.

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