Bigger Isn't Always Better - IndexUniverse.com

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BKLN: Senior Loans Made Easy By Cory Banks New ETFs launch all the time. This year alone, issuers have brought 215 new products to market, according to the IndexUniverse ETF Classification System. Many are useful, relevant products, but few become superstars. The launch of the PowerShares Senior Loan Portfolio (NYSE Arca: BKLN), however, was something altogether different. Released on March 3, the fixedincome product accumulated more than $100 million in assets under management in a little more than 60 days, paving the way for similar filings from First Trust and Guggenheim. And yet, most investors don’t understand “senior loans” as a discrete asset class, which begs the question: What are these things, and how can investors effectively use BKLN? First In Line In Case Of Default Senior-loan funds—also called bank-loan, prime-rate, loan-participation or sometimes floating-rate funds—provide access to a specific breed of corporate debt. Often issued by companies with less-than-stellar credit ratings, senior loans originate from an era when savings and loans would issue debt to just about anyone—and often set themselves up for default in the process. The term “senior loan” is literal; loan holders are the first in line if the borrower defaults, receiving the highest-ranking claim on a defaulted firm’s assets, above unsecured debt, preferred stock and equity holders. When they start auctioning off the office chairs, it’s the senior loan holders who pocket the proceeds. Unlike most debt notes, the interest paid on senior loans “floats,” adjusting according to changes to the London Interbank Offered Rate (Libor) or prime rate. The variable rate, which typically adjusts on a monthly, quarterly or annual basis, means that these loans perform well when interest rates increase, while fixed-rate debt instruments suffer significant price erosion. With such benefits, it’s amazing that senior loans haven’t been available in an ETF until now. In fact, historically, the only way to access senior loans has been through closed-end mutual funds that can trade at uncontrollable premiums. Wrapping senior loans in an ETF structure solves those premium concerns, giving investors exposure to the true underlying liquidity of the seniorloan market, and no doubt accounting for much of BKLN’s asset growth. Betting On Interest Increases Throughout 2011, fixed-income gurus like Bill Gross have insisted that interest rates would skyrocket in reaction to the country’s rapidly increasing debt. Pimco, Gross’ investment firm and the issuer of popular actively managed bond ETFs like the Pimco Enhanced Short Maturity Strategy (NYSE Arca: MINT), has witnessed firsthand the broad sell-off of government debt, in anticipation of an uptick in interest rates and a looming debt debacle. As Gross himself proclaimed in a New York Times interview from April, “Americans have assumed the roller coaster goes one way. It’s been a great thrill as rates descended, but now we face an extended climb.” The appeal of senior loans is the floating interest rate component, in combination with a call on higher-credit-risk corporate debt. Moving away from Treasurys to a product using senior loans, then, can make sense: As rates climb, each loan held in BKLN will eventually reset to the new, higher interest level. That adaptability to interest hikes is a core component of BKLN’s role in an investment strategy. Looking Under The Hood Unlike most fixed-income funds, BKLN can fully replicate its benchmark, the S&P LSTA U.S. Leveraged Loan 100 Index. The ETF holds all 100 facilities in the index, itself reflecting the top 100 facilities in the leveraged loan market. Most of the issues mature in the short term, with just more than half of the holdings in the one- to five-year range. The longest maturity date in the portfolio is in January 2023, a rarity in BKLN’s holdings. The term “facilities” is important: Not only does BKLN hold actual debt notes from firms like Tribune Co., Intelsat Jackson Holdings, and Texas Competitive Electric; it also holds shares of three closed-end mutual funds that focus on senior loans. This may concern investors. Closedend funds are often subject to massive premiums and/or discounts in prices, and that variability can directly affect the price authorized participants pay when building creation units of BKLN—especially if a premium collapses. However, such funds only make up 3.4 percent of BKLN’s portfolio, so the concern isn’t too large. BKLN’s launch predated a growing theme of floating interest rates in bond ETFs. The Market Vectors Investment Grade Floating Rate ETF (NYSE Arca: FLTR) and iShares Floating Rate Note Fund (NYSE Arca: FLOT) both launched within months of the senior loan product, and both invest in instruments that adjust interest rates according to flexible schedules. However, BKLN remains unique for its focus on highyield and noninvestment grade issues, making it a better fit for yield hunters with a high risk tolerance. Although the senior nature of the debt should assuage investors, it’s important to note that in certain cases, senior loans may lose their first-in-line status. This is especially true of senior loans issued by holding companies whose debt is actually subordinate to the debt of the holding companies’ subsidiaries. Opening New Doors BKLN seems tailor-made for today’s yield-seeking, interest-rate-wary investor. With recent worries over the U.S. debt ceiling dominating headlines and the search for income rapidly taking over 2011’s core investment themes, BKLN opens doors to new strategies for your ETF portfolio. “It’s the only unique play in ETFs to get high-yield, corporate exposure 12 ETFR • October 2011 9
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