If You’re Wary of Emerging Market Bond Funds, Consider Bank Loan Funds

From David Fabian: There is no doubt that 2016 has been a good year for ETF investors directing their capital towards income-generating asset classes.  The combination of a rising stock market and falling interest rates have helped push prices higher across virtually every segment of the economy.

This of course has depressed current yields.  But on a total return basis, you are looking fairly good as long as you didn’t do something foolish like sell in February and remain in cash.

In early August, I wrote an article about the scarcity of value in income generating ETFs due in large part to this broad push higher.  It essentially broke down the current landscape from both a yield and performance category across stocks, bonds, and alternative assets.  I like to analyze these trends to pinpoint areas that look overheated and those that may offer greater hope for the future.

The two strongest income producing sectors were emerging market bonds and REITs.  Obviously these areas were showing signs of technical strength, but also give me pause for their susceptibility to a sharper pullback.  Much of the momentum has been driven by a stretch for yield, for example, the iShares JPMorgan USD Emerging Market Bond Fund ETF (NYSE:EMB), and a perception of low-volatility and safety (REITs).  Two trends that can easily turn and catch late-adopters off guard if interest rates attempt even a modest nudge higher.


Furthermore, the areas of slow growth or outright negative returns were centered on international dividend paying stocks and master limited partnerships.  Both of these sectors potentially offer greater long-term value on a relative basis, but are also much higher up the risk scale as well.

Right in the middle of the pack was an area I hadn’t considered in quite a while – bank loans.  These instruments became widely known during the 2013 taper tantrum as a potential way to sidestep rising interest rates.  Their weakness is more aligned with credit risk and liquidity (smaller market) than a typical investment grade fixed-income security.

These debt instruments go by many different names, i.e. senior loans, leveraged loans, bank loans, or floating rate notes.  They are predominantly issued by companies with a below investment grade rating, and carry floating coupon rates.  The coupon rate is typically indexed to a widely followed interest rate index, such as 3-month LIBOR.

One of the advantages of these floating rate securities is that coupon floors exist so as rates fall investors still receive respectable income.  However, as interest rates rise, the commensurate coupon rate can also rise, which can increase the mark-to-market value of the security.  Lastly, the effective duration is typically tied to the security’s reset rate, which is typically no longer than 60-90 days.

A widely-followed proxy for the bank loan market is the PowerShares Senior Loan Portfolio (BKLN).  This ETF has $5.4 billion invested in an index of just over 100 loans using a market-cap weighted methodology.  BKLN has a 30-day SEC yield of 5.45% and income is paid monthly to shareholders.

Two other available options are the SPDR Blackstone / GSO Senior Loan ETF(SRLN) and First Trust Senior Loan Fund (FTSL).  Both of these ETFs are actively managed funds with a broader number of holdings and over three years of trading history.

We recently opted to purchase a starter position in FTSL for clients in our Strategic Income Portfolio after a thorough analysis of the strengths and weaknesses each fund brings to the table.  Primarily, we believe that the broader diversification, credit research, and flexibility of an active fund is an advantage in this unique sector.  FTSL has been one of the better performing funds over the last several years and currently carries an outsized cash position that we believe will be an advantage moving forward.


In our opinion, the relative under performance of bank loans this year combined with the potential for a sideways to uptrend in interest rates offer an attractive opportunity.  This is particularly acute after taking profits from other highly appreciated sectors of the fixed-income and alternative income markets that added to our healthy cash position.

We are also pleased to note that this sector has remained stable throughout the uptick in Treasury yields over the last several months.


Make no mistake – bank loans are not a panacea for the specter rising interest rates and several other opportunities exist that are directly correlated to the price movement of Treasury yields.  These loans still carry noteworthy credit risk, similar to high yield bonds, which is a characteristic that we regularly evaluate.  Investors should also be mindful that actively managed funds in this category carry a premium in their embedded expenses due to the cost of maintaining the non-index strategy.

Our goal is to use these tools to supplement our existing fixed-income positionsand deploy capital in areas that we feel offer greater reward potential than cash or conventional bonds.

This article is brought to you courtesy of FMD Capital.

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