Bigger Isn't Always Better - IndexUniverse.com

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
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ETFR • October 2011 9