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Summary BKLN holds loans that primarily have maturities within 2 to 10 years, but the fund doesn’t move with typical junk bond movements. The loans in the ETF benefit from having LIBOR based loans so their coupons reset on a regular basis. When high yield bonds were dipping during the taper tantrum, loans like these were much steadier. Investors should be seeking to improve their risk adjusted returns. I’m a big fan of using ETFs to achieve risk adjusted returns relative to the portfolios that a normal investor can generate for themselves after trading costs. One of the funds I’m looking into is the PowerShares Senior Loan Portfolio ETF (NYSEARCA: BKLN ). I’ll be performing a substantial portion of my analysis along the lines of modern portfolio theory, so my goal is to find ways to minimize costs while achieving diversification to reduce my risk level. I’ll cover the holdings of the fund and then look at its performance in what I would consider a reasonable portfolio. Expense Ratio The net expense ratio is .66%. That’s fairly high compared to the junk bond funds I would normally consider. On the other hand, BKLN is holding a senior loan portfolio rather than a simple junk bond portfolio and the expense ratio is in line with the norms for this sector. Maturity The portfolio has a fairly simple standard of holding loans with a maturity from 1 to 5 years. These senior loan ETFs will be following an index and when those indexes are updated they often exclude any loans with a maturity of less than one year. It might seem like this would cause the fund to have quite a bit of interest rate risk, but as you’ll see, that isn’t entirely the case. Interest Rate Sensitivity The following chart shows the price movements on two indexes. Note that these are indexes being measured rather than directly measuring the performance of any single ETF tracking that index. The normal high yield funds suffered much worse than the loan index. Even though both are exposed to a material amount of credit risk, BKLN has loans with their coupons resetting based on LIBOR. Because of this resetting feature the duration exposure is substantially lower. This should make the loan ETFs an interesting option for investors seeking for acceptable yields while already holding enough bonds that they are concerned about the duration risk. Credit Credit risk is still a factor here. That shouldn’t be a surprise since we are talking about a high yield portfolio. Building the Portfolio This hypothetical portfolio has an aggressive allocation for the middle aged investor, but should be fairly reasonable for a younger investor. Investors nearing retirement should aim for a significantly more conservative portfolio unless they have a high risk tolerance and a high ability to actually bear the risk. Retirees depending on the portfolio value should aim for something more conservative than this. A total of 40% of the portfolio value is placed in bonds. That makes it appear to be a fairly reasonable allocation for the middle aged investor. However the position in junk bonds is highly susceptible to losses at the same time as the equity positions because fear in the market will cause junk bonds to be sold off along with equity. You’ll also notice that emerging market bonds also have a positive correlation with domestic equity markets due to the influence of fear. The portfolio assumes frequent rebalancing which would be a problem for short term trading outside of tax advantaged accounts unless the investor was going to rebalance by adding to their positions on a regular basis and allocating the majority of the capital towards whichever portions of the portfolio had been underperforming recently. Because a substantial portion of the yield from this portfolio comes from REITs and interest, I would favor this portfolio as a tax exempt strategy even if the investor was frequently rebalancing by adding new capital. The portfolio allocations can be seen below along with the dividend yields from each investment. Name Ticker Portfolio Weight Yield Vanguard High Dividend Yield ETF VYM 30.00% 3.16% iShares U.S. Real Estate ETF IYR 10.00% 3.82% Vanguard FTSE Developed Markets ETF VEA 10.00% 2.94% Vanguard FTSE Emerging Markets ETF VWO 10.00% 3.12% Vanguard Emerging Markets Government Bond Index ETF VWOB 10.00% 4.73% Vanguard Long-Term Corporate Bond Index ETF VCLT 10.00% 4.54% Vanguard Long-Term Government Bond Index ETF VGLT 10.00% 3.12% I include the yield from each investment to aid investors looking for a higher yielding portfolio. If nothing else, this should provide a very quick reference point for which other ETFs mentioned here might also be useful in constructing your own portfolio. I picked VYM as a replacement for SPY in this portfolio due to it having a significantly stronger dividend yield and the assumption that domestic equity would be the core of the portfolio. The next chart shows the annualized volatility and beta of the portfolio since October of 2013, courtesy of Investspy.com. (click to enlarge) Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. To make it easier to recognize the risk impact of the various positions, I’ve built this portfolio to be equal weight with the exception of the position in VYM. Since this is the core of the portfolio, I’ve allocated 30% to the ETF. You can also see that VGLT has a negative total risk impact on the portfolio. When you see negative risk contributions in this kind of assessment it generally means that there will be significantly negative correlations with other asset classes in the portfolio. The position in VCLT is also very low in the impact on total portfolio risk. That is because these are very long duration high quality bonds. Even though they are not treasuries, they have a much higher correlation with treasury securities than with equity securities. Thinking of Modifications If an investor wanted to use something like this as a high yield portfolio while significantly reducing the risk, one way to do it would be to cut the allocations to VEA and VWO and to increase the allocations to VGLT and VCLT. That would create a lower risk portfolio overall and it would strengthen the yield on the portfolio. It should be noted that this modification would reduce the expected level of returns over the long term. A quick rundown of the portfolio I put together the following chart that really simplifies the role of each investment: Ticker Role in Portfolio VYM Core of Portfolio IYR Yield and exposure to equity REITs VEA International diversification VWO International diversification VWOB Strong Yield with International Diversification VCLT Moderate yield, moderate risk VGLT Strong Negative Correlation to Equity Correlation The chart below, created by Invest Spy shows the correlation of each ETF with each other ETF in the portfolio. Blue boxes indicate positive correlations and tan box indicate negative correlations. Generally speaking lower levels of correlation are highly desirable and high levels of correlation substantially reduce the benefits from diversification. (click to enlarge) Conclusion The difference between BKLN and a typical high yield fund can be seen by factors such as its fairly low correlation with other debt instruments. Even VWOB, the emerging market bond fund, is only showing a 35% correlation with BKLN. It is interesting to note that BKLN has a higher correlation with VYM and SPY than any other investments in the table. In short, the credit exposure in the portfolio is the dominating factor in price movements as the ETF will generally move up and down with the rest of the economy rather than trading with other bond portfolios. That means this kind of ETF is better suited to the risk averse investor that is overweight on bonds and looking for a small allocation to increase yields without having it go up down with his other bond investments. Just keep in mind that this is still a high yield fund, even with very little duration exposure. Scalper1 News
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