Author’s Note: This article was published to members of the CEF/ETF Income Institute on November 2, 2022.
I continue covered SPDR Blackstone / GSO Senior Loan ETF (SRLN), the largest and highest yielding senior loan ETF in the market, 1 year in front. In that article, I argued that his SRLN’s high expense ratio and credit risk outweighed its low interest rate risk. Without aggressive rate hikes by the Federal Reserve, the fund seemed destined to underperform. Since then, the Federal Reserve has hiked rates aggressively, leading to modest returns and dividend growth for SRLN. It wasn’t the scenario I envisioned, or at least not at this level of intensity, but the fund performed as expected under the current circumstances.
SRLN has performed relatively well in recent months, but still suffers from high expense ratios and credit risk. Absent another unprecedented rate hike, the fund should underperform going forward. Therefore, we will not invest in the fund at this time.
Senior Secured Loan Basics
SRLN is an actively managed fund that invests in senior secured loans. These securities have certain characteristics that are key to understanding the fund and its expected performance in specific economic scenarios.
Senior secured loans are Senior Means that most/all other company loans and debts will be paid off first in case of bankruptcy.
Senior secured loans are Safe In other words, investors are promised to receive real assets in the event of bankruptcy.
As a result, senior secured loans tend to have relatively high recovery rates and reduce risk and loss during downturns.
Senior secured loans are virtually always Floating interest rate Loans, and if the Federal Reserve raises interest rates, you will see higher coupon/interest payments.
Senior secured loans are generally non-investment grade Loans issued by smaller, less mature, higher risk companies.
The above characteristics are common to all variable rate loans, including these security-focused funds like SRLNs. With this in mind, let’s look at the SRLN itself.
SRLN – Overview and Benefits
SRLN is an actively managed fund focused on senior loans, with minor investments in fixed rate bonds and cash.
SRLN’s portfolio is highly diversified, investing in over 500 securities from all relevant industry segments.
Concentration is slightly above average, with the fund’s top 10 stocks representing over 16% of its value, but not excessive.
The SRLN’s diversified holdings reduce the risk, volatility, and potential for material loss or performance degradation from bankruptcy or default of individual issuers.
The SRLN focuses on senior secured loans, which as previously mentioned are generally non-investment grade securities, which represent 85% of the fund’s value. Investment grade securities make up the remaining 15%, which includes the fund’s fixed income, cash investments, and possibly a small portion of its loans.
Sub-investment grade securities are riskier than average, but come with relatively high yields. The SRLN itself yields 5.3%, which is significantly higher than the bond fund average, but comparable to high-yielding corporate bond funds.
SRLN’s above-average yield increases expected shareholder returns and yields similar returns.
SRLNs focus on senior loans, which, as mentioned above, are typically variable rate loans. These loans will see higher interest payments as the Federal Reserve raises interest rates, increasing fund returns and increasing shareholder dividends. SRLN’s dividend has increased by more than 40% year-to-date, or 2.0%. High-yield corporate bond ETFs have significantly higher than average growth, but ETF dividends are somewhat volatile, so the difference in growth could simply be due to volatility. Might be so not persist into the future.
The SRLN dividend should almost certainly see further growth as the Federal Reserve has hiked rates by about 4.0% year-to-date and more hikes are expected. A further +2.0% dividend increase is expected going forward, although much depends on future Federal Reserve interest rate policy.
SRLN’s variable interest rate loans are market price when interest rates rise. Most of the time, when interest rates rise, investors sell older, lower-yielding bonds and loans and buy newer, higher-yielding alternatives. You don’t need to do this for variable rate loans, as these securities pay higher interest rates when interest rates rise. As such, SRLN should have relatively low capital losses when interest rates rise, similar to YTD.
A yield of 5.3% above the SRLN average and low interest rate risk are key benefits for the fund and its shareholders and make a reasonably compelling investment thesis. The fund’s many risks and drawbacks, at least in my opinion, seem to outweigh these benefits. Let’s see.
SRLN – Risks and Disadvantages
high credit risk
SRLNs focus on non-investment grade securities issued by relatively weak counterparties that may face payment difficulties during economic downturns and recessions. These scenarios should cause default rates to skyrocket and security prices to fall, leading to capital losses for funds and their investors. As expected, this was the case in Q1 2020.
As seen above, SRLN suffered relatively large double-digit losses in the most recent recession. Losses were much larger than the bond fund average, but comparable to those of high-yield corporate bond funds.
SRLN’s high credit risk has resulted in relatively large losses during previous recessions and will almost certainly lead to similar losses in the future. recessionThe economic situation is somewhat worse now and could get worse as the Federal Reserve continues to raise rates. For risk-averse investors concerned with these issues, the high credit risk of SRLNs may lead to contract failure.
Moderately ineffective interest rate hedging
SRLN Variable Rate Loan Technically There is little to no interest rate risk, but the Fund’s focus on non-investment grade securities has somewhat muted this impact.
Yields on non-investment grade securities depend on the Federal Reserve’s intervention rate, which acts as the base rate, and credit spreads, which depend on economic and market conditions. Not only if Federal Reserve (Fed) rates rise, as has been the case year-to-date, but if economic conditions deteriorate, as investors grow weary of investing in relatively risky securities during tough times. Yields on non-investment grade securities should be higher even when things get worse. Spreads are technically more or less important to all fixed income securities, especially These tend to have wider, more volatile spreads, which is important for the riskier ones.
SRLN only moderately Protect investors from Federal Reserve rate hikes. Spreads are also important, and if spreads widen too, the fund may suffer losses when interest rates rise. This is the case year-to-date with credit spreads widening as economic conditions deteriorate.
It leads to capital loss of SRLN.
Importantly, these losses were well below the bond fund average, so the fund A few Protection against rising interest rates, but only partially.
Generally speaking, SRLN’s high credit risk is well below its investment theme.instead of looking at the loss price As it rises, the SRLN suffers losses when: Spread Rise, different but equally important, risk or negative.
high expense ratio
SRLN is a relatively expensive fund with an expense ratio of 0.70%. This is slightly higher than the average for his ETFs, which are actively managed, and significantly higher than the average for bond funds. High costs directly undermine shareholder returns and, all else being equal, should lead to long-term underperformance.
As expected, SRLN has been underperforming against high yield corporate benchmarks since the beginning. These securities have relatively low interest rate risk and have performed relatively well over the past few months, making the underperformance even greater than short-term high yield corporate bonds.
In my opinion, investors should always try to minimize fees and expenses. Because doing so is one of the only sure and risk-free ways to increase your returns. The strongest funds may more than make money with higher yields, performance, or other benefits, but SRLN’s benefits don’t seem to be significant enough to justify the 0.70% fee. Recall that the fund’s most important advantage is interest rate risk mitigation, and the fund has suffered relatively large capital losses even this year.
SRLN offers investors an above-average dividend yield of 5.3% and has relatively low interest rate risk. On the other hand, funds are relatively expensive and carry high credit risk. I am not currently investing in any fund as the risks and downsides of the fund outweigh the benefits in my opinion.