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Boost your yield and your principal gets nibbled. Here’s how to assess the trade-off.

“I bought the Invesco Senior Loan ETF, ticker symbol BKLN, in 2017 and haven’t seen the light of day since. I bought it when I learned that it’s floating rate and if interest rates rise it should not lose value. Any advice, taking into consideration the likelihood of rates rising around the corner? I am thinking to sell. Should I?”

Saed, Arabia

My answer:

You are disappointed. You had in mind that your fixed-income investment would combine a high yield with a low risk to principal. I regret to inform you that this combination is impossible.

This point can be rephrased: There is no free lunch in investing.

Over the past decade your fund has combined a high yield with modest damage to principal. The bottom line is a decent total return. If we get steadily rising rates in the next decade, the fund might well beat out alternative ways to collect interest.

The short answer to your question is that you shouldn’t be in a hurry to sell. The longer answer:

Someone who lends money, which is what you are doing when you own this fund, potentially takes two risks. One is that interest rates might rise, which would lower the value of a fixed income stream. The other risk is that you don’t get your money back.

Senior loan funds pretty much eliminate the first risk because these loans have floating interest rates. They do not eliminate the second risk. Indeed, the loans are mostly made to junky, highly leveraged companies, and sometimes junky companies go bust. You can lose principal.

The Invesco fund came out 11 years ago with a starting price per share of $25. In the pandemic crash of 2020 the shares sank, almost hitting $17. They have recovered to $21. Since you probably paid something close to $23, you’re hurting.

Don’t condemn Invesco. It has delivered exactly what it promised its customers: a floating-rate fund that pays better interest than you could get on a money-market fund but suffers dings to principal every now and then.

“Senior loan” is Wall Street jargon for a security that looks and acts like a corporate bond, except that it typically has an interest rate that is reset every month or so, typically is issued by a corporation with a weak balance sheet, often is illiquid and often is backed by specific collateral. The collateral means that, when an issuer sinks beneath the waves, the loan has some salvage value. Still, principal gets eroded.

What you have, in effect, is a junk money-market fund. Is it a bad deal?

You should put this exchange-traded fund in the context of other ETFs that hold fixed-income assets. As noted above, there are two dimensions of risk, credit risk and rate risk. You can subject yourself to either or both of these risks. Risk-takers get rewarded with an enhanced yield. They also get shellacked on occasion with a price decline.

Picture a 2×2 array. In the safe corner, at the lower left, is a fund that has little exposure to either credit or rate risk: the Vanguard Short-Term Treasury ETF (VGSH). Credit quality is AAA. Rate risk, as measured by duration, comes to 1.9 years, which means that the price of fund shares is as sensitive to changing interest rates as a zero-coupon bond due in 1.9 years.

In the upper left corner: the Vanguard Total Bond Market ETF (BND). It mostly owns government paper so its credit quality, as reported by Morningstar, is AA, almost as good as the quality of the Treasury fund. But with a duration of 6.8 years it has more than triple the rate risk.

In the lower right: your senior loan fund. Its duration of 0.1 year means that it is immune to rate rises, just as you were told when you bought in. But the credit quality is pretty awful. Morningstar gives it a grade of B, two steps into junkdom.

In the upper right: the SPDR Bloomberg High Yield Bond ETF (JNK). You get a double dose of risk from junk bonds. The fund’s portfolio has a B credit grade and a 3.8-year duration.

In the past ten years all four funds have endured some erosion of principal. The share price declines ranged from 1.6% for the safest of the bunch, invested in short-term Treasuries, to 15% for the junk bond fund.

But loss of principal is tolerable if it comes with a hefty coupon. Over the past decade that junk bond fund had the best total return (coupons minus price erosion), at 4.2% a year. Total return on the short Treasuries was at the other end of the spectrum at 0.9% a year.

Returns for the two other funds landed in between. BND (high credit quality, long duration) averaged 2.3% a year. Your fund (low quality, short duration) averaged 2.9%.

What about today’s yields? You can look them up, but they don’t give you a fair view of expected returns. The junk-bond fund has a yield, as defined by the Securities & Exchange Commission, of 5.6%. But this yield figure does not incorporate a loan loss provision. If it did, the yield would probably shrink to a number below 3%.

Your junk money-market sports an SEC yield of 3.1%. Allow for loan losses and you’re really earning 2% or less.

Besides loan losses, corporate credits come with a hidden option cost. The issuer usually has the right to prepay the debt. It will exercise this option if rates fall or its finances improve. If rates rise and its financial condition deteriorates, you’re stuck with the bad paper. Tails you lose, heads you break even. It’s hard to put a number on the implicit option built into corporate debt, but it probably shaves a quarter-point or more off your expected return.

If you knew that the next decade will deliver, as the previous one did, a strong economy and subdued inflation, the risk-on JNK would be the best bet. A weak economy with low inflation would make BND the winner. Your BKLN would be nice if the economy holds up and the Fed keeps printing money with abandon. The short-term Treasuries are the thing to have if stagflation is our destiny.

If you don’t know what the future holds in store, spread your bets around. My advice is to hang onto a portion of your loan fund shares but move some money into other kinds of fixed income.

Do you have a personal finance puzzle that might be worth a look? It could involve, for example, pension lump sums, estate planning, employee options or annuities. Send a description to williambaldwinfinance—at—gmail—dot—com. Put “Query” in the subject field. Include a first name and a state of residence. Include enough detail to generate a useful analysis.

Letters will be edited for clarity and brevity; only some will be selected; the answers are intended to be educational and not a substitute for professional advice.

More in the Reader Asks series:

What’s The Risk I Will Be Double-Crossed If I Delay Social Security?

Should I Pay Off My Mortgage?

Should I Put All My Bond Money Into TIPS?

Directory of Reader Ask columns

Source: Forbes

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