FLBL: Moving This Loan Fund To Hold (Rating Downgrade)

Thesis

We started covering the Franklin Senior Loan ETF (BATS:FLBL) almost a year ago with a ‘Buy’ rating. The name has outperformed since our coverage:

The total return for the fund is almost 7%, with most of the move coming from the dividend yield.

The high rates environment and lack of significant defaults have contributed to a smooth sailing for the name, generating the said 7% with a low drawdown. While the market is now working on establishing when we are going to have a rate cut, or if we are even going to get one this year, defaults are starting to climb.

In this article, we are going to re-visit the name within the current macro back-drop, and walk an investor through our reasoning for making FLBL a solid Hold at this stage of the cycle.

Rates have stayed elevated, but defaults are climbing

Floating rate funds have been propped-up in the past year by higher rates for longer. While the market came into 2024 pricing in 5 to 6 Fed cuts, it was forced into a reversal as the data came in stronger than expected. Currently, it is looking at roughly 45 bps of cuts for 2024, or roughly 2 cuts for the year:

The above graph, courtesy of Creative Planning, is showing the implied Fed Funds rate via Fed Funds futures which are traded daily in the market. Please notice the end of 2024 implied rate of 4.87%. This level is going to get traded daily, and if data continues to come in strong, will move up to 5.33%, i.e. implying no cuts for the year. Conversely, much weaker than expected data, especially on unemployment figures, will get market participants to price in more cuts for the year. High rates are favorable to FLBL since it allows the fund to pass to investors a high all-in yield rate.

When we will ultimately see rate cuts by the Fed, we will have the investor community rotated into fixed assets, given the ability to lock-in duration for the next cycle.

The other important risk factor in the ETF is constituted by defaults. If default rates stay low, then FLBL is able to have a high stable base of assets which pay their requisite interest rate. Conversely, an increase in defaults can put a dent in the underlying collateral, as well as move credit spreads higher. Within the current macro framework, we are witnessing an increase in defaults:

As illustrated by the above graph from LCD, loan default volume has started to pick up in 2024, increasing significantly since January. We are not sure if this is a strong trend or just a seasonal factor at this stage. Please note the seasonal high default volume in 2023 in certain months, which subsequently reverted lower. A couple of months do not make a trend, but it is an item to keep a close look on and consider from an investment standpoint.

PineBridge, a large player in the leveraged loan market, expects slightly higher than normal default rates this year, but still contained:

We expect the default rate (by par amount outstanding) to reach the 3% area, slightly above the historical average, with new filings and distressed exchanges primarily concentrated among loans rated B- and below. Technicals should be supportive of loan prices over the next several quarters due to both healthy CLO issuance (the largest source of demand for leveraged loans) and limited net loan supply.

CLO issuance has been a large absorber of new volume, especially in light of the development of an active ETF market based on CLO collateral, a positive development for retail investors.

Single-B collateral

While the fund has an 18% double-BB rated bucket, most of the underlying names fall in the single-B category:

Single-B loans are on the riskier side, and the recent move in spreads to very tight levels make them susceptible to credit spread widening. At this stage, we are not very concerned with the default probability, because we are unsure if the rise in default volumes is a trend or a seasonal factor. However, spreads are very tight currently, and spreads are to be bought when they are wide (i.e. loan prices are low).

The higher the preponderance of single-B and CCC names in a fund, the higher the gap-up in spreads if fundamentals do indeed deteriorate. A lower rating indicated a company which is fundamentally more hamstrung than higher rated names, either by the amount of debt undertaken or cyclical factors in the underlying business.

Analytics

• AUM: $0.36 billion.
• Sharpe Ratio: 0.58 (3Y).
• Std. Deviation: 4.49 (3Y).
• Yield: 8.92% (30-day SEC yield)
• Premium/Discount to NAV: n/a.
• Z-Stat: n/a.
• Leverage Ratio: 0%.
• Expense Ratio: 0.45%

When to buy and when to hold

Buying an asset is a matter of considering the underlying risk factors ‘cheap’. In our case, this translates into high risk free rates and wide credit spreads. While risk free rates are still high, spreads have contracted significantly in light of the ‘soft landing’ scenario.

Although the fund has a very low volatility profile, it nonetheless makes little sense to buy single-B spreads here. An investor in the name should continue to hold since the overall yield levels are attractive, and only consider adding on a significant bout of risk-off, that would see credit spreads widen to attractive levels.

Conclusion

FLBL is a leveraged loan exchange-traded fund. The vehicle comes from Franklin Templeton, and represents a take on higher Fed Funds and leveraged loan spreads. The name is attractive in the current rates environment, but exposes appealing entry points only on the back of market dislocations and credit spread widening. With single-B leveraged loan spreads at very tight levels an investor is well served to Hold here.