A Banking ETF Worth the Risk

05/08/2013 9:45 am EST

Focus: ETFs

Samuel Lee

Editor, Morningstar ETFInvestor

If you’re looking to participate in the comeback of the financial sector, this bank-loan ETF may stoke some interest, writes Samuel Lee of Morningstar ETFInvestor.

PowerShares Senior Loan Portfolio (BKLN) is the first bank-loan ETF. Now, I’m not a fan of “innovative” ETFs. I’m not sure a passive bank-loan fund is the best way to gain access to this obscure and illiquid corner of the high-yield fixed-income market.

That said, bank loans offer higher-quality yield than do most junk-bond funds, and they zero out duration risk. But I still think PIMCO 0-5 Year High Yield Corporate Bond Index ETF (HYS) is a better way to get high yield and low duration risk. I’m more confident in PIMCO’s trading process than Invesco’s.

It’s difficult to accurately assess the economic cost of a passive fund that tracks an illiquid market. So far, however, BKLN has done a decent job tracking its index.

Firms issuing bank loans are highly leveraged, which increases probability of default and bankruptcy, and, in turn, higher yields. Unlike most high-yield bonds, bank-loan coupons change every 30 to 90 days. The rate is a fixed percentage spread over a floating base rate—typically Libor.

Bank loans are the most senior security in the capital structure. With yields in the high-yield bond sector near historic lows, bank loan funds are looking more attractive on a relative basis.

As of the end of March, iShares iBoxx $ High Yield Corporate Bond (HYG) has a current yield-to-maturity of 5.13%. For comparison, BKLN, which tracks the 100 most-liquid bank loans, has a yield-to-maturity of 5.69%. For an additional 56 basis points of yield, you get a portfolio of bank loans, which are safer than traditional fixed-rate high-yield bonds.

Also, bank loans have historically had a lower average default rate of 3%, compared with high-yield bonds’ average default rate of 4.75%. Furthermore, all bank loans are secured by collateral. As such, their historical average recovery rate (65%) has been much greater relative to the high-yield sector (44%), which is dominated by unsecured bonds.

If defaults—or more importantly interest rates—rise, we believe bank loans would be the better choice of the two for conservative investors.

Morningstar has been tracking the bank-loan sector since 1989, and the available data show that bank loans typically have positive performance even during recessions. The only year that bank loans posted a negative return over this span was 2008, when they plummeted 29%.

Much of that loss was due to the overissuance of new loans in the wake of the leveraged buyout boom of 2006 and 2007. Many companies used the bank loan market as their preferred source of financing, especially those engaged in leveraged buyouts.

BKLN tracks the S&P/LSTA US Leveraged Loan 100 Index, which is composed of the 100 largest bank loans. The fund currently has about 150 holdings and uses sampling to mimic the results of the underlying index.

The bank-loan market can become illiquid, so the ETF has special liquidity provisions. First, because of the unique nature of bank loans and the specialized trading desk required to transact them, BKLN will take creations and redemptions in cash instead of the traditional in-kind method, eliminating the traditional tax advantage ETFs have over mutual funds.

Also, the fund has a credit line. Borrowings are limited to 33 1/3% of the fund’s total assets. If BKLN uses this provision, the fund will become leveraged similar to a closed-end fund.

Finally, the fund can hold up to 20% of its portfolio in bank-loan CEFs. In the event of a market panic, the portfolio manager can use the credit line, sell individual loans, or sell CEFs. This increased flexibility should improve the overall liquidity of the ETF.

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