BKLN Senior Loan ETF: Better Options Out There (NYSEARCA:BKLN)

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The Invesco Senior Loan ETF (NYSEARCA:BKLN) is an index ETF that invests in senior secured floating rate loans from non-investment grade companies. The BKLN’s holdings are almost entirely adjustable rate loans, which see higher interest payments and stable asset prices when they earn interest rise. As a result, BKLN tends to outperform other bond indices when rates rise, as it has done year-to-date.

BKLN is a reasonable investment choice, especially in a rising interest rate environment, but there are several similar CEFs with higher yields, discounts, and overall value propositions. These include BlackRock Floating Rate Income Strategies Fund (FRA) and Invesco Senior Income Trust (VVR). In my opinion and under the current market conditions, these CEFs offer better investment opportunities compared to BKLN. Therefore, I would not currently invest in BKLN.

Floating Rate Bonds versus Fixed Rate Bonds – Analysis and Comparison

BKLN invests in floating rate bonds while most bond funds invest in fixed rate bonds. There are significant differences between these two sub-asset classes that are material to the Fund’s performance, characteristics and investment thesis. So let’s start with a quick comparison between these before we look at the fund itself.

Fixed rate bonds pay a fixed rate of interest throughout their life. Market conditions may change, but the interest rate on the bonds remains the same. Most bond funds focus on fixed-income bonds because they tend to be the most common type of bond. For example, the iShares 7-10 Year Treasury Bond ETF (IEF), the largest and most well-known Treasury index ETF, invests exclusively in fixed income/Treasuries. Let’s take a quick look at one of the fund’s underlying bonds. The following dates refer to the 3rd quarter of 2021.

BKLN US Government Obligations

BKLN Annual Report 2021

The binding highlighted above can be described as follows. IEF has loaned the government $778,840,000 at an interest rate of 1.25% with a maturity date of 8/15/31. IEF’s bond will be repaid in full at maturity However, if necessary, the Fund could sell this bond on the open market at any time. The market price of this bond can deviate significantly from the original investment depending on economic and industry conditions. conditions to have changed significantly since then as higher rates of inflation and tighter monetary policy have led to higher interest rates across the board. 10-year Treasury interest rates, the benchmark Treasury rate and closest analogue to this particular bond, have risen from 1.25% to 2.80% over the past few months.

10-year Treasury interest rate
Data from YCharts

Importantly, the above only applies to newly issued government bonds. Older government bonds maintain their lower interest rates, including IEF’s 1.25% Treasury bond. As should be obvious, investor demand for a 1.25% legacy Treasury will be pretty low if there are newer issues yielding more than double. Low investor demand translates directly into lower prices, with the price of this particular bond down about 12%. The table below is for the third quarter of 2022, interest rates have fallen slightly but not significantly since then.

Treasury bond yields

BKLN Corporate Website – Chart by Author

Lower bond prices mean capital losses for IEF and its shareholders, with the fund down 9.7% year-to-date.

IEF 7-10 year government bond price change
Data from YCharts
Most bond and bond funds are quite similar to the IEF on these issues. Interest rates are fixed and at very low levels, so investor demand has fallen significantly as the Federal Reserve raises rates, resulting in lower prices and lost capital for shareholders. This has been the case for IEF and most other relevant bond funds year-to-date.
IEF, BND, LQD, HYG price change
Data from YCharts

The underlying stocks of BKLN work a little differently than above. BKLN focuses on senior secured loans, which are predominantly originated due to market conventions variable Prices. As market conditions change, the interest rate on these bonds will also change, helping to stabilize their price when market conditions are turbulent. As an example, let’s look at the largest participation of the BKLN. The table below applies to the 3rd quarter of 2021.

BKLN Loan interest with variable senior maturity

BKLN Annual Report 2021

The binding highlighted above can be described as follows. BKLN has loaned Charter Communications (CHTR) $96,712,000 at an interest rate of 1.75% plus Libor 1 million with a due date of 02/01/2027. The 1-month Libor is a reference interest rate that closely follows the Federal Funds Rate, the interest rate set by the Federal Reserve. Federal funds rates were close to 0% last year and 1-month Libor was 0.09%, giving the bond a 1.84% yield.

With very few exceptions, when the Federal Reserve raises interest rates by X%, the 1M Libor increases by X%. The 1-month Libor has risen over the past 12 months and, as expected, has closely tracked US Federal Reserve rate hikes.

1 month LIBOR rate

Bankrate.com

The BKLN’s bond is pegged to Libor, which is tied to Federal Reserve interest rates, so as interest rates rise, so does the interest rate paid by this bond. According to management, this bond now pays an interest rate of 3.42%, which is a year-over-year increase, as expected. Higher interest rates help stabilize bond demand and prices. As expected, prices for this particular bond have remained relatively stable. There were some Losses, mainly because Federal Reserve rate hikes take time to feed back into bond markets and the Fed has been slow to start raising rates this cycle.

BKLN is a broad-based, diversified senior secured / floating rate loan index ETF. The vast majority of its holdings share characteristics similar to the above bond, with all the benefits that come with it.

Since the holdings of the BKLN have variable interest rates, these will increase when interest rates rise, as is currently the case. Higher interest rates mean higher income for the fund and higher dividends for shareholders, a significant benefit for them. As shown in the example above, the bonds are from BKLN to have have seen their interest rates rise as expected in recent months.

On the downside, it takes a while for higher interest payments on bonds to translate into higher dividend payments. BKLN’s dividends have increased from $0.0541 to $0.0660 over the trailing 12 months, a 22% increase. dividends to have increased, but the rate hikes were significantly larger than this. Because of this, the fund achieves a relatively low return of 3.3%. To more positive Keep in mind that dividends should continue to rise in the coming months, which will bode well for investors.

BKLN Dividend
Data from YCharts
Because BKLN holdings experience higher interest payments when interest rates rise, their prices are comparatively stable when interest rates rise. This was the case YTD as expected.
BKLN, BND, IEF, LQD, HYG price change
Data from YCharts

BKLN sees higher earnings and more stable share prices when interest rates rise, so the fund should outperform its peers in that case. This was the case YTD as expected.

BKLN, BND, IEF, LQD, HYG price change
Data from YCharts

BKLN outperforms when rates rise, as they are currently. The fund’s investment thesis is simple, clear and strong, at least in my opinion. While there’s nothing inherently wrong with the fund, there are several stronger options out there. Let’s have a look.

Fast peer comparison

BKLN is the largest and most popular senior loan ETF on the market today, but it has many competitors. There are several ETFs with similar holdings and characteristics, including the SPDR Blackstone Senior Loan ETF (SRLN) and the First Trust Senior Loan Fund (FTSL). There are also several Senior Loan CEFs including FRA and VVR.

CEFs in particular are looking extremely attractive in the current market conditions. Recent losses and weakening economic fundamentals have caused CEF discounts to widen, with these three CEFs trading at large double-digit discounts to NAV.

FRA vs VVR Discount/Premium at NAV
Data from YCharts
The same CEFs trade at significantly higher distribution yields than BKLN, partly because of their discounts and partly because of their focus on higher-yielding credit.
FRA, VVR, BKLN Distribution Yield
Data from YCharts

Higher distribution yields mean stronger long-term total shareholder returns, both on a NAV and price basis.

BKLN, FRA, VVR price change
Data from YCharts
Importantly, these same CEFs are not significantly riskier than BKLN and have suffered similar losses over the past 12 months.
BKLN, FRA, VVR NAV change
Data from YCharts

FRA and VVR have higher distribution yields, total shareholder returns and discounts to NAV compared to BKLN. Given these conditions, I see no reason to invest in BKLN beyond these two CEFs.

Conclusion

BKLN is an index ETF that invests in senior secured floating rate loans from non-investment grade companies. BKLN is outperforming in a rising interest rate environment, making the fund a reasonable investment choice in current market conditions. While there’s nothing fundamentally wrong with the fund, there are several similar CEFs with higher yields, discounts, and overall value propositions. Therefore, I would not currently invest in BKLN.

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