John Sommer
Last summer, I wrote a cautious article on the Invesco Senior Loan ETF (NYSEARCA:BKLN), warning that rising leveraged loan defaults could pose a headwind to the BKLN ETF.
However, since my article, the BKLN ETF has actually returned a handsome 9% total return (Figure 1).
Figure 1 – BKLN has returned 9% since June (Seeking Alpha)
Was I wrong to expect weak performance from BKLN and what is my outlook for the fund going forward?
Brief Fund Overview
First, for those new to the Invesco Senior Loan ETF or the leveraged loan asset class, the BKLN ETF tracks the investment results of the Morningstar LSTA US Leveraged Loan 100 Index (“Index”). This index passively tracks the market value weighted performance of the 100 largest institutional leveraged loans, sort of like how the S&P 500 Index tracks the stock performance of the 500 largest companies.
In layman terms, leveraged loans are loans extended to companies with considerable amounts of existing debt or poor credit history. As a result, leveraged loans carry a higher risk of default and thus charge higher rates of interest to the borrowers. Historically, leveraged loans were also called bank loans (hence the ticker BKLN), but in modern times, private credit funds and pensions also extend these loans to borrowers.
BKLN has $7.4 billion in assets and charges a 0.65% expense ratio.
Defaults Increased As Expected
Since the time of my prior update, leveraged loan defaults have continued to increase as I warned. According to S&P Global, leveraged loan defaults rose to 1.9% in October 2023, and the rating agency expects defaults to reach 3.0% by September 2024 in their base case scenario (Figure 2).
Figure 1 – Leveraged loan defaults continue to climb (S&P Global)
Not only has the pace of defaults picked up, but borrower quality have deteriorated as well, with the number of issuers rated B- and CCC/C both increasing, suggesting more defaults may be forthcoming (Figure 3).
Figure 3 – Issuer quality have decreased (S&P Global)
BKLN Returns Fueled By Risk Appetites
Given rising defaults and decreasing credit quality, how did the BKLN ETF generate its handsome returns in the past few months?
There are two parts to this story. First, with the rise of short-term interest rates due to the Fed’s 2022/23 policy rate increases, leveraged loan yields are now quite substantial, as they are priced off of a floating rate benchmark like SOFR plus a credit spread. For example, the BKLN ETF currently has a 30-Day SEC yield of 8.2%, which funds its generous 8.3% distribution rate (Figure 4).
Figure 4 – BKLN has 8.2% SEC 30-Day yield (invesco.com)
The second piece of the BKLN puzzle has been the Federal Reserve’s ‘dovish pivot’ last year, which loosened financial conditions and released pent up risk appetites.
According to the Chicago Fed’s National Financial Conditions Index (“NFCI”) and contrary to the Fed’s rhetoric, financial conditions were barely restrictive in the Fall of 2022, and have since loosened to early 2022 levels, before the Federal Reserve even started raising interest rates (Figure 5)!
Figure 5 – Financial conditions are as loose as in early 2022 (Chicago Fed)
Extremely loose financial conditions have pushed investors to seek risky investments, compressing high yield credit spreads (a proxy for leveraged loan credit spreads) to near all-time lows (Figure 6).
Figure 6 – High yield credit spreads near all-time lows (St. Louis Fed)
Hence, despite rising defaults, the combination of high floating rate benchmarks plus tightening credit spreads have driven strong returns for the BKLN ETF.
Mind The Gap Between Defaults And Spreads
However, looking forward, I continue to advise caution with respect to credit investments like the BKLN ETF. If we overlay actual leveraged loan defaults against high yield credit spreads, we see a worrisome gap between the two series (Figure 7). While defaults have been heading higher, credit spreads have collapsed to cycle lows.
Figure 7 – There is a disconnect between rising defaults and complacent credit spreads (Author created with data from S&P Global and St. Louis Fed)
Historically, the two series are closely correlated, as credit spreads are basically the compensation investors demand to bear the risk of defaults. When defaults are high and rising, investors demand higher spreads. However, in this cycle, investors are complacently demanding lower spreads as defaults rise.
Readers should note that I am not predicting a 2020 or 2008/09-style blow-out in credit spreads. I am merely pointing out that investors are not being properly compensated for the default risk they are bearing.
BKLN Priced For Perfection
If we look at 2024 forward returns for the BKLN ETF, I believe it will be significantly lower than 2023’s 11.6% return (Figure 8).
Figure 8 – BKLN historical returns (morningstar.com)
To estimate forward returns, let us start by assuming SOFR stays constant at ~5.3%, as the Fed may not be cutting interest rates anytime soon given recent disappointing inflation reports (Figure 9).
Figure 9 – 90 day SOFR rates (St. Louis Fed)
On top of this SOFR yield, we can add a high yield credit spread, say ~3.2%, simlar to where the high yield benchmark is currently. That means without factoring in defaults, investors may be looking at gross yields of ~8.5%, similar to BKLN’s portfolio yield currently.
However, against this yield, we need to subtract leveraged loan defaults, which is expected to be 2-3%, according to S&P Global. If we assume 30-50% credit recoveries, investors are therefore looking at a 1-2% drag from defaults. So total returns may be closer to 6.5-7.5%, assuming credit spreads stay constant.
If credit spreads were to widen back to be consistent with the current level of defaults (i.e 4-5% instead of 3% on high yield spread), then forward total returns may drop to sub-5% as the loans in BKLN’s portfolio will be re-priced lower. Compared to current risk-free rate of 5.25% from treasury bills, BKLN’s estimated forward return does not look appealing.
Risk To Being Cautious
Of course, I could be wrong in my view on credit. Credit spreads may be a leading indicator and actual defaults could moderate in the coming months. However, with credit spreads basically at cycle lows, I do not believe there will be any additional tailwinds from further credit spread tightening, so investors may see forward returns of 7-8% (assuming an optimistic default scenario).
Conclusion
The BKLN ETF has defied rising leveraged loan defaults to deliver a strong 2023 as high floating rate yields and tightening credit spreads boosted returns.
However, looking forward, I believe forward returns may not be as robust as the recent past, as a clear dislocation between credit spreads and actual defaults have developed. A normalization of credit spreads could lead to sub-par returns for the BKLN ETF in 2024.
