BKLN: A Near-9% Yield As We Await The Fed’s Decision (NYSEARCA:BKLN)

fazon1 It’s a good time to invest in debt. The economy is still hot despite Fed fund rates being at twenty-year highs for nearly a year (August 2023 was when it hit 5.33%). Inflation is stubborn, and there doesn’t seem to be a light at the end of the interest rate tunnel just yet. Effective Fed Fund Rates | Federal Reserve Bank of St. LouisWhen those rate cuts will start to happen has now become a multi-trillion dollar question – in a literal sense, because the United States’ Real GDP growth looks like it’s slowed to a crawl at 1.4% as of Q1 2024, compared to 3.4% in Q4 2023. Real GDP | BEA.govAll said, the economy is not in great shape. It’s resilient, yes, but there’s a very delicate balance right now where a single large catalyst can easily disrupt this resilience. We don’t know which catalyst might cause that, but we do know that there are several of these potentially disruptive eventualities in the near-term. Thankfully, it’s not all gloom and doom for retail investors. The fact that interest rates have been high for so long also means that corporations with investment-grade ratings have issued billions in senior debt with very high coupons, and that’s the opportunity we’ll be investigating today, with the subject being the Invesco Senior Loan ETF (NYSEARCA:BKLN). Thesis: At a TTM yield of 8.76% and underlying coupon rates ranging between 3.5% and as high as 11.7%, this seems like a good place to store your dry powder if that catalyst I mentioned should have an overblown impact on the economy. Please be aware of the elevated risks due to the high percentage of non-investment-grade debt in the ETF’s portfolio. I recommend a Buy – caveated with the risks I discuss in this article. Understanding BKLN’s Leveraged Loan Portfolio A lot of investors are averse to debt investing because credit ratings can dramatically shift overnight, essentially turning your investment-grade portfolio into junk in the blink of an eye. This is a valid concern when interest rates are high because it follows that default rates are also high. Look at how the junk market is already seeing the effects of higher-for-longer interest rates in this excerpt from Bloomberg: Already, the US leveraged loan default rate has climbed to 6.22% as of Feb. 29 from 6.16% a month earlier on a trailing 12-month basis, coming closer to the peak rate of 7.7% during two of the last three recessions, according to TD Securities Inc. strategist Hans Mikkelsen. If the junk market is feeling the heat already and interest rates remain this high for much longer, it’s a reasonable assumption to make that the next set of dominoes to fall will be the barely-investment-grade debt issued by large corporations. This is why it’s crucial to understand the credit risk composition of BKLN, so you can make a more informed decision on whether or not to invest in this vehicle. BKLN Fund Holdings Data as of 06/25/2024, tables by authorWhat’s clearly observable from this pivot table is that very few of BKLN’s investments are investment grade – 4.2% per S&P and an even more severe 3.6% per Moody’s. I’ve provided a reference table below for your convenience, courtesy The Association of Corporate Treasurers. ACT PDFThat said, this is not necessarily a negative, because the overall EPS trend of Corporate America is on the rise. However, this is definitely a high-risk scenario because we’re talking about a debt pool that’s already rated below investment grade. That sounds logical to me, because companies’ cost of debt currently stands at 5.34%, per data from AlphaSpread. Remember, this is for (SP500) companies, which means the cost of debt for smaller public companies issuing debt should be much higher, and that’s reflected in the coupon rates of BKLN’s debt assets; hence, the near-9% yield. So, what you’re essentially stepping into with this ETF is a high-risk/high-reward scenario where any major catalyst could set off a chain reaction of credit defaults from these smaller corporate houses. If you’re willing to take on that risk and hold this ETF for at least a few years, there’s also an additional duration risk when you look at BKLN’s underlying assets’ debt maturity profile. Invesco data, graph by authorThe problem with holding long-dated debt securities is that any change in interest rates is bound to affect the price of the security. However, I don’t see this as a problem when interest rates are high, because as they come down eventually, the price of the instrument should rise. And when you have a debt portfolio that’s skewed toward longer maturities, this phenomenon is more pronounced because the longer the duration, the greater the sensitivity to interest rate changes. Bond investors know this well, and it’s a principle that can be applied to most types of fixed-income securities. In the case of BKLN, that should serve you well, but, again, you need to be aware of the risk of defaults if interest rates remain this high for too much longer, so that’s something we need to try and anticipate. In closing, I posit that this is a calculated gamble, as any astute investment should be. The only difference here is that the risk is greater because the potential reward is that much greater, with emphasis on the word “potential.” I’m confident rating it a Buy, but you’re the one putting up the money, so please do your own due diligence before investing in anything I recommend.

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