FTSL - FTSL: Unleveraged Floating Rate Loans 8.4% Yield

2023-07-20 16:03:56 ET

Summary

• The First Trust Senior Loan Fund is an actively managed ETF that primarily invests in first lien senior floating-rate bank loans, with a current yield of 8.4%.
• The fund has low market risk due to its floating rate nature and low duration, but it does carry credit risk, as market sell-offs can widen spreads on underlying loans.
• The transition from LIBOR to SOFR in the leveraged loan market has been slow, potentially leading to higher yields for FTSL if issuers have to start paying an Alternative Base Rate.

Thesis

The First Trust Senior Loan Fund ( FTSL ) is an exchange traded fund. The vehicle is an actively managed one, and focuses on leveraged loans. As per its literature:

The fund's primary investment objective is to provide high current income by investing primarily in a diversified portfolio of first lien senior floating-rate bank loans. The fund's secondary investment objective is the preservation of capital. Under normal market conditions, the fund will invest in at least 80% of its net assets in Senior Loans that are made predominantly to businesses operating in North America and may also invest up to 20% of its net assets in non-Senior Loan debt securities, warrants, equity securities and securities of other investment companies.

Given its ETF structure, the fund does not have any leverage. However, on the back of the meteoric rise in risk free rates, the fund is now exposing an 8.4% 30-day SEC yield:

Please note that you can use the fund manager's website for the 30-day SEC yield (Seeking Alpha currently shows only a trailing twelve months yield which we believe is not appropriate to use in a rising rates environment). Leveraged loans are a floating rate asset class, and they price at a spread to risk free rates. The asset class has made the transition from LIBOR to SOFR, although the path was not easy. We expand more on this point in the section below.

Given the floating rate nature of the asset class the duration here is extremely low at 0.5 years. Leveraged loans are also called senior loans because they usually have a 1st lien interest on the assets of the issuer. That translates into very high recovery rates. Generally high recovery levels make an asset class more stable from a volatility standpoint because investors know they will usually get their money back, even in a bankruptcy proceeding.

During normalized economic environments this asset class in an unleveraged format is fairly boring, since returns are muted. However, in today's high interest rate environment the yield is very enticing. Compare today's yield with the 4.5% 30-day SEC yield from only two years ago!

Analytics

• AUM: $2.2 billion
• Sharpe Ratio: 0.71 (3Y)
• Std. Deviation: 4.3 (3Y).
• Yield: 8.4%
• Premium/Discount to NAV: n/a
• Z-Stat: n/a
• Leverage Ratio: 0%
• Composition: Fixed Income - Leveraged Loans
• Duration: 0.5 yrs
• Expense Ratio: 0.86%

Market Risk and Credit Risk

The fund runs two types of risks for the return profile: market risk and credit risk. The market risk is benign, given its low duration and floating rate nature. We have seen this during the 2022 fixed income sell-off where FTSL did quite well, ending the year with only a -2.5% performance, versus -13% for the iShares Core U.S. Aggregate Bond ETF ( AGG ), a proxy for the overall fixed income market.

Credit risk is the more pertinent one here, since market sell-offs can widen the spreads on the underlying loans, causing mark to market losses and sometimes even outright defaults. The maximum drawdown observed last year during a risk-off event was roughly -5%, during the August to October period. That drawdown figure closely correlates with the fund's standard deviation. Expect a similar figure for the next significant market sell-off event.

LIBOR Transition

Please note an interesting structural feature for the leveraged loan market - the LIBOR Transition . LIBOR ceased to be measured and published at the end of June:

The publication for one-week and two-month U.S.-dollar LIBOR ceased at the end of 2021. The remaining tenors of U.S.-dollar LIBOR are scheduled to cease publication after June 30, 2023. The end of LIBOR has precipitated the need for an alternative benchmark rate.

Source: The SEC

All of the leveraged loan space has historically re-set off of LIBOR, and its transition to SOFR has been very slow. In fact, a month before the deadline there were still substantial amounts of issuers without amendments to their original loan agreements:

June 6, 2023 at 7:30 AM EDT

Billions of dollars of leveraged loans are running short on time to transition away from the scandal-plagued London interbank offered rate before the benchmark is phased out at the end of June.

A little over half of the underlying loans in CLOs still need to make the switch, according to Barclays Plc research as of May 30. CLOs own about two-thirds of the institutional leveraged loan market, and are a proxy for understanding what’s happening in the $1.4 trillion asset class.

While new loan contracts were barred from using Libor at the start of last year, existing debt was given until mid-2023 to make the switch. The expectation was that most deals would transition to Libor’s replacement, known as SOFR, as they were refinanced. But as the deadline approached, the normal pace of refinancing dropped off significantly amid quickening inflation, rising interest rates and growing macroeconomic risks.

Source: Bloomberg

Those issuers that have not done amendment or have robust fall back language in place that addresses the permanent cessation of LIBOR might need to start paying an Alternative Base Rate ('ABR'), which is usually calculated as the Prime Rate plus 50 bps, which would be significantly higher than LIBOR. Ultimately this translates into a higher yield paid by the FTSL collateral as applicable.

Holdings

The fund contains mostly leveraged loans:

The vehicle tends to be overweight single-B credits, which account for over 60% of the fund's composition:

The fund has a granular build, with most names under 2% of the portfolio, and a sectoral breakdown that favors 'Software' at 19.5% of the portfolio, followed by 'Insurance' at 13%.

Performance

The fund has a low volatility return profile when compared to leveraged loan CEFs, but has performed fairly robustly long term:

The other large leveraged loan ETF in the space is BKLN, while two of our favorite leveraged loan CEFs are the Invesco Senior Income Trust ( VVR ) and the Apollo Tactical Income Fund ( AIF ). The two CEFs are leveraged, hence the higher risk / higher reward total return profiles. To note that FTSL manages to outperform BKLN on a five year look-back.

Conclusion

FTSL is a floating rate debt actively managed ETF. Leveraged loans are a low volatility asset class and they have historically provided low returns when held without leverage. Things have changed in the past year with the Fed raising rates by 500 bps. FTSL is now yielding 8.4% with a small -5% drawdown last year.

The fund has virtually no market risk from rates given its floating rate nature, but can sustain mark to market losses if credit spreads widen substantially. We are going to use last year's drawdown as a risk scenario for the fund, with ample room here for the carry (i.e. dividend) to overcome that.

We are of the opinion we will have higher rates for longer, so this asset class looks attractive. Given the current 'Extreme Greed' reading in the CNN Fear & Greed Index , we would look to dollar cost average into this name, rather than Buy the entire position now.

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