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BKLN: Higher Yields Without The Duration Risk

Summary BKLN holds loans that primarily have maturities within 2 to 10 years, but the fund doesn’t move with typical junk bond movements. The loans in the ETF benefit from having LIBOR based loans so their coupons reset on a regular basis. When high yield bonds were dipping during the taper tantrum, loans like these were much steadier. Investors should be seeking to improve their risk adjusted returns. I’m a big fan of using ETFs to achieve risk adjusted returns relative to the portfolios that a normal investor can generate for themselves after trading costs. One of the funds I’m looking into is the PowerShares Senior Loan Portfolio ETF (NYSEARCA: BKLN ). I’ll be performing a substantial portion of my analysis along the lines of modern portfolio theory, so my goal is to find ways to minimize costs while achieving diversification to reduce my risk level. I’ll cover the holdings of the fund and then look at its performance in what I would consider a reasonable portfolio. Expense Ratio The net expense ratio is .66%. That’s fairly high compared to the junk bond funds I would normally consider. On the other hand, BKLN is holding a senior loan portfolio rather than a simple junk bond portfolio and the expense ratio is in line with the norms for this sector. Maturity The portfolio has a fairly simple standard of holding loans with a maturity from 1 to 5 years. These senior loan ETFs will be following an index and when those indexes are updated they often exclude any loans with a maturity of less than one year. It might seem like this would cause the fund to have quite a bit of interest rate risk, but as you’ll see, that isn’t entirely the case. Interest Rate Sensitivity The following chart shows the price movements on two indexes. Note that these are indexes being measured rather than directly measuring the performance of any single ETF tracking that index. The normal high yield funds suffered much worse than the loan index. Even though both are exposed to a material amount of credit risk, BKLN has loans with their coupons resetting based on LIBOR. Because of this resetting feature the duration exposure is substantially lower. This should make the loan ETFs an interesting option for investors seeking for acceptable yields while already holding enough bonds that they are concerned about the duration risk. Credit Credit risk is still a factor here. That shouldn’t be a surprise since we are talking about a high yield portfolio. Building the Portfolio This hypothetical portfolio has an aggressive allocation for the middle aged investor, but should be fairly reasonable for a younger investor. Investors nearing retirement should aim for a significantly more conservative portfolio unless they have a high risk tolerance and a high ability to actually bear the risk. Retirees depending on the portfolio value should aim for something more conservative than this. A total of 40% of the portfolio value is placed in bonds. That makes it appear to be a fairly reasonable allocation for the middle aged investor. However the position in junk bonds is highly susceptible to losses at the same time as the equity positions because fear in the market will cause junk bonds to be sold off along with equity. You’ll also notice that emerging market bonds also have a positive correlation with domestic equity markets due to the influence of fear. The portfolio assumes frequent rebalancing which would be a problem for short term trading outside of tax advantaged accounts unless the investor was going to rebalance by adding to their positions on a regular basis and allocating the majority of the capital towards whichever portions of the portfolio had been underperforming recently. Because a substantial portion of the yield from this portfolio comes from REITs and interest, I would favor this portfolio as a tax exempt strategy even if the investor was frequently rebalancing by adding new capital. The portfolio allocations can be seen below along with the dividend yields from each investment. Name Ticker Portfolio Weight Yield Vanguard High Dividend Yield ETF VYM 30.00% 3.16% iShares U.S. Real Estate ETF IYR 10.00% 3.82% Vanguard FTSE Developed Markets ETF VEA 10.00% 2.94% Vanguard FTSE Emerging Markets ETF VWO 10.00% 3.12% Vanguard Emerging Markets Government Bond Index ETF VWOB 10.00% 4.73% Vanguard Long-Term Corporate Bond Index ETF VCLT 10.00% 4.54% Vanguard Long-Term Government Bond Index ETF VGLT 10.00% 3.12% I include the yield from each investment to aid investors looking for a higher yielding portfolio. If nothing else, this should provide a very quick reference point for which other ETFs mentioned here might also be useful in constructing your own portfolio. I picked VYM as a replacement for SPY in this portfolio due to it having a significantly stronger dividend yield and the assumption that domestic equity would be the core of the portfolio. The next chart shows the annualized volatility and beta of the portfolio since October of 2013, courtesy of Investspy.com. (click to enlarge) Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. To make it easier to recognize the risk impact of the various positions, I’ve built this portfolio to be equal weight with the exception of the position in VYM. Since this is the core of the portfolio, I’ve allocated 30% to the ETF. You can also see that VGLT has a negative total risk impact on the portfolio. When you see negative risk contributions in this kind of assessment it generally means that there will be significantly negative correlations with other asset classes in the portfolio. The position in VCLT is also very low in the impact on total portfolio risk. That is because these are very long duration high quality bonds. Even though they are not treasuries, they have a much higher correlation with treasury securities than with equity securities. Thinking of Modifications If an investor wanted to use something like this as a high yield portfolio while significantly reducing the risk, one way to do it would be to cut the allocations to VEA and VWO and to increase the allocations to VGLT and VCLT. That would create a lower risk portfolio overall and it would strengthen the yield on the portfolio. It should be noted that this modification would reduce the expected level of returns over the long term. A quick rundown of the portfolio I put together the following chart that really simplifies the role of each investment: Ticker Role in Portfolio VYM Core of Portfolio IYR Yield and exposure to equity REITs VEA International diversification VWO International diversification VWOB Strong Yield with International Diversification VCLT Moderate yield, moderate risk VGLT Strong Negative Correlation to Equity Correlation The chart below, created by Invest Spy shows the correlation of each ETF with each other ETF in the portfolio. Blue boxes indicate positive correlations and tan box indicate negative correlations. Generally speaking lower levels of correlation are highly desirable and high levels of correlation substantially reduce the benefits from diversification. (click to enlarge) Conclusion The difference between BKLN and a typical high yield fund can be seen by factors such as its fairly low correlation with other debt instruments. Even VWOB, the emerging market bond fund, is only showing a 35% correlation with BKLN. It is interesting to note that BKLN has a higher correlation with VYM and SPY than any other investments in the table. In short, the credit exposure in the portfolio is the dominating factor in price movements as the ETF will generally move up and down with the rest of the economy rather than trading with other bond portfolios. That means this kind of ETF is better suited to the risk averse investor that is overweight on bonds and looking for a small allocation to increase yields without having it go up down with his other bond investments. Just keep in mind that this is still a high yield fund, even with very little duration exposure.

Stock Picking Or Index Investing: Comparing Average And Median Price To Cash Flow Ratios Globally

Summary When looking at country level stock market valuation ratios, it is always useful to look both at median and average statistics. Wide valuation dispersion allows stock pickers to find relative value plays within a country index. Narrow valuation dispersion tends to top-line calls on the overall country index. When looking at country level stock market valuation ratios, it is always useful to look both at median and average statistics. If you only look at average statistics, the resulting valuation ratios can sometimes be very skewed . When several companies are dramatically re-rated lower it drags down the average ratio statistics and can make an entire countries stock market look a lot cheaper than it actually is. A good example of this can been seen when looking at MSCI Brazil. The average price to cash flow ratio for MSCI Brazil is just 4.6x. If an investor just looks at this than one might think that market looks as cheap as it has at any point since 2009. However, the median price to cash flow ratio is still 8.6x which is right in the range that valuation ratios have been since mid-2012. Therefore, there most be a wide dispersion of valuations among individual stocks for investors to choose from. On the other hand, you have a situation like MSCI Hong Kong where the spread between average and median valuations is just 14 basis points. With average and median valuations so close, most likely there isn’t a lot of variation among valuation levels among individual stocks within the country index. In the charts below, we are going to group various country indexes into two baskets: large valuation spreads and small valuation spreads. (click to enlarge) (click to enlarge) Large Spreads – Potential For Individual Security Analysis (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) Small Spreads – Index Investing May Make More Sense (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) Its tough to make an investment decision purely on valuation spreads. However, there are a couple of investment conclusions that I think we can make. First, when the spread between average and median valuations is large this means most likely that there is a wide dispersion of valuation levels among individual stocks within a country index. This would seem like an environment for stock pickers to be able to find opportunities to apply individual security analysis to unearth stock ideas. Second, when the spread between average and median valuation is small than it would seem that it would be tougher to find very many individual security ideas, at least from a relative valuation stand point, and investors would be better off buying or selling the entire country index (or ETF). Relevant Tickers: MCHI , EDEN , EWG , EWQ , EWH , EWJ , EWW , EWM , EPHE , EWS , ERUS , EWP , EZA , EWD , TUR , ICOL , EWA , EWC The original posting of this article can be found here . All data was created by the author and sourced from Gavekal Capital, MSCI and FactSet.

Reaves Utility Income Fund: What To Make Of The Rights Offering

Reaves Utility Income Fund intends to do a rights offering. Forget about the minutia of the actual offering. Think – instead – about the reason for the offering. Reaves Utility Income Fund (NYSEMKT: UTG ) is one of my favorite closed-end funds, or CEFs, for those seeking utility exposure and dividend income. Its dividend history is nothing short of impressive and it has historically been a solid performer on a total return basis. That said, what should you make of the recent announcement of a rights offering? Impressive record One of the most notable aspects of UTG is its monthly distribution. Since the CEF first initiated a distribution in 2004, it has been increased eight times, most recently in December of last year. The distribution has never been cut, despite the fund living through the deep 2007 to 2009 recession. And, perhaps more impressive, the distribution has never included return of capital. Although the 6% or so distribution yield won’t excite those looking for 10% yields, it’s high enough to be meaningful and yet low enough to be sustainable. History has, so far, proven that out. Performance, meanwhile, is solid. The fund’s trailing 10-year return through September is an annualized 9% or so. That’s notably above Vanguard Utility ETF’s (NYSEARCA: VPU ) 6.6% annualized gain. Both numbers assume the reinvestment of distributions. To be fair, UTG’s mandate is broader than VPU’s, allowing it to invest in areas like oil, but the comparison provides at least a reasonable benchmark. That said, the more recent performance has been, well, not as good. UTG was down roughly 10% through September while VPU was down just 6.6% or so. It has been a bad year for utilities as well as some of the other areas in which UTG invests, so this doesn’t look like it’s an issue of management losing its way. Still, it’s not a good thing to see the value of an investment you own fall 10%. So why is UTG raising cash? Which might lead some investors to wonder why UTG recently announced a rights offering . Shareholders can get one right for every UTG share and buy a new share for every three rights they own. On the surface, this could look like a risky proposition since the fund is doing relatively poorly this year. If you are really cynical you might even suggest it’s a way to cover up a shortfall on the dividend front by spitting out the new cash as return of capital distributions. But step back and think bigger picture. Yes, UTG is doing poorly this year performance wise. Which, in turn, means its holdings aren’t doing so well, since UTG is nothing more than a pooled investment vehicle. If management believes this is an opportunity to buy good companies at depressed prices, its only option is to sell other holdings or raise more cash. But it can’t do that easily because it’s a closed-end fund. Thus, it has to go with a rights offering. In fact, the last time UTG did a rights offering was in 2012 . That was a relatively weak year for the fund, with a total return of around 5.8% compared to 2011’s over 14% gain (which was down from 2010’s 27% gain). In the CEF’s 2012 annual report it explained : “In August the Fund raised $144 million from a transferable rights offering. We view the rights transaction as a long‐term positive outcome for the Fund and its investors. The offering proceeds were invested principally in proven, current holdings of utility equities, increasing their portfolio weighting from just over 41% to 53%. The new investments enhanced the Fund’s current and potential future dividend yield. The outlook, after the offering, for Fund returns over the long term, gave us the confidence to announce in September the sixth increase in the monthly dividend rate since the Fund’s inception in 2004.” Essentially, the fund used the cash raised from the rights offering to buy more companies it knew well and believed were undervalued. It isn’t a stretch to think management is looking to do essentially the same thing this time around, too. If you are a Reaves shareholder this is probably a good deal for you. Will it be a good deal in the next six months? Maybe, maybe not. But longer term the CEF appears to be of the opinion that now is a good time to put money to work. And that should work out for you if you plan to stick around for some time.