Tag Archives: coupons

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.

FLOT Vs. FLRN: The Best Floating Rate ETF

The Fed rate hike may be just around the corner and investors have started probing every possible safe option in a likely rising rate environment. A barrage of solid economic data, including a more-than-seven-year low unemployment rate in August, an improving service sector, decent consumer confidence, and a pretty strong housing market raised speculations over the first rate hike in more than nine years. Investors should note that while fixed income investing underperforms in a rising rate environment, there are several plays, even in the bond market, that could ward off rising rate worries. A floating rate instrument is such an option. Floating rate notes are investment grade bonds that do not pay a fixed rate to investors but have variable coupon rates that are often tied to an underlying index (such as LIBOR) plus a variable spread depending on the credit risk of the issuers. Since the coupons of these bonds are adjusted periodically, these are less sensitive to an increase in rates compared to traditional bonds. Unlike fixed coupon bonds, these do not lose value when the rates go up, making the notes ideal for protecting investors against capital erosion in a rising rate environment. Below we highlight two popular floating rate bond ETFs and try to figure out which one is a better bet at the current level: iShares Floating Rate Note ETF (NYSEARCA: FLOT ) This is the most popular fund in the floating rate securities market space that follows the Barclays US Floating Rate Note < 5 Years Index. Holding 458 securities, the fund has an average life of 1.78 years and effective duration of 0.14 years. The product has amassed over $3.60 billion in its asset base while trades in volume of 650,000 shares per day on average. Sector-wise, the fund invests over half of its assets in banking followed by 8.4% weight in areas with no guarantee. Companies like JPMorgan (NYSE: JPM ) (4.12%), Goldman (NYSE: GS ) (4.07%) and Citigroup (NYSE: C ) (3.49%) are top three holdings of the fund. Bonds with 1-2 years of maturity have the highest exposure of 33.17% in the fund while bonds with 0-1 years take the second position with 28.69% weight. Expense ratio comes in at 0.20%. The fund is off 0.02% so far this year (as of September 11, 2015) and yields about 0.48%. SPDR Barclays Capital Investment Grade Floating Rate ETF (NYSEARCA: FLRN ) This ETF tracks the Barclays U.S. Dollar Floating Rate Note < 5 Years Index with average maturity of 1.73 years and modified duration of 0.12 years. It holds 445 securities and has been able to accumulate $387 million in its total asset base. The fund charges 15 bps in annual fees while volume is moderate at under 30,000 shares. Sector-wise, the product is tilted toward the financial sector with 61% exposure followed by the industrial sector (25.43%). Individual holding-wise, no stock holds more than 1.60% in the fund. Goldman gets the top priority followed by Kommunalbanken (0.97%) and Toronto-Dominion Bank (NYSE: TD ) (0.91%). Here also, bonds with 0-1 years and 1-2 years of maturity hold top positions with 30.88% and 36.21%, respectively. It has lost 0.3% in the year-to-date timeframe and has a dividend yield of 0.59% (as of September 11, 2015). Which One is the Better Bet? While both options are pretty intriguing in a rising rate environment and quite similar in nature, there's a subtle difference between the two that might give one ETF an edge over the other in a rising rate environment. The chart below details the two bond ETFs: FLOT FLRN Effective Maturity 1.78 years 1.73 years Effective Duration 0.14 years 0.12 years Default Risks Slightly higher FLRN Slightly lower than FLOT Interest Rate Risks Slightly higher FLRN Slightly lower than FLOT Concentration Risks Slightly High Slightly Low Expense Ratio 0.20% 0.15% Yield 0.48% 0.59% To sum up, both FLOT and FLRN both have high exposure in the better-performing financial sector. Both handle around 450 bonds and certain international exposure, but are dollar-denominated in nature. Yet, FLRN appears a less risky product compared with FLOT going by various risk matrixes. FLRN is cheaper too. Link to the original article on Zacks.com

TLO: Long Term Treasury Securities For Portfolio Stability

Summary TLO offers investors a low expense ratio and a negative beta. The average effective duration is around 17 years but the actual breakdown on securities is in the 10-15 range and heavily in the 20 to 30 year range. Negative correlation with major equity investments makes TLO an intelligent choice for diversifying the portfolio. For investors that are going heavy on bond funds, I would start with SCHZ and then add on TLO as a second option. For investors going heavy on equity and only using bonds for diversification, I would start with ZROZ and then use TLO as the secondary option. The SPDR Barclays Long Term Treasury ETF (NYSEARCA: TLO ) is an option for investors seeking exposure to the longer portion of the treasury yield curve. This kind of allocation can be used for an investor seeking interest income (2.6% yield) and willing to take on duration risk. However, I think the best use of this fund by a significant margin is to use it in a portfolio that goes overweight on equity securities and uses regular rebalancing to take advantage of the highly negative correlation between TLO and the major market indexes. Expense Ratio The fund has an expense ratio of .10% which is very solid for bond ETFs. I’d still like to see it get into the single digits because I’m very frugal with expense ratios, but I wouldn’t complain about including an ETF with a .10% expense ratio in my portfolio. Quick Figures Over 99.8% of the holdings of the security are invested in domestic government debt. This is quite simply a quick way to get government debt into your portfolio without paying high trading costs. Rationale If the purpose of the position is to keep the portfolio properly balanced and reduce the volatility of the portfolio, then it makes sense to treat trading costs as a major issue due to rebalancing. TLO is one of the options on Schwab’s free ETF trading system which was a major reason for it going onto my short list of treasury ETFs. Fixed Income Statistics The statistics below provide a rough idea of the numbers on the portfolio. The bonds trade at a substantial premium due to having higher coupons. (click to enlarge) While those numbers are useful for an initial impression, I think it is important to also look at the breakdown along the yield curve because this is not a bullet fund where the bonds are all maturing in a very tight date range. Maturity The SPDR Barclays Long Term Treasury ETF is primarily using the 20 to 30 year debts but also contains a material allocation to the 10 to 15 year range. (click to enlarge) Having a small allocation to the 10 to 15 year range should make TLO less volatile than some other treasury security ETFs. On one hand that is a positive factor in isolation but for investors using their bond allocation strictly for negative correlations the longest exposures and higher volatility can produce the appropriate hedge against equity volatility with smaller allocations. Building the Portfolio I put together a hypothetical portfolio using only ETFs that fall under the “free to trade” category for Charles Schwab accounts. My bias towards these ETFs is simple, I have my solo 401k there and recently moved my IRA accounts there as well. When I’m building a list of ETFs to consider I want to focus on things I can trade freely so that I can keep making small transactions to buy more when the market falls. Within the hypothetical portfolio there are no expense ratios higher than .18%. Just like trading costs, I want to be frugal with expense ratios. The portfolio is fairly aggressive. Only 30% of the total is allocated to bonds and I would consider that the weakest area in the portfolio. I’d like to see more bond options (with very low expense ratios) show up on the “One Source” list for free trading. (click to enlarge) A quick rundown of the portfolio The Schwab U.S. Dividend Equity ETF (NYSEARCA: SCHD ) is a dividend index. The Schwab U.S. Broad Market ETF (NYSEARCA: SCHB ) is a broad market index. The Schwab U.S. Large-Cap ETF (NYSEARCA: SCHX ) is focused on blended large cap exposure. The Schwab International Equity ETF (NYSEARCA: SCHF ) is developed international equity. The Schwab Emerging Markets ETF (NYSEARCA: SCHE ) is emerging market equity. The Schwab International Small-Cap Equity ETF (NYSEARCA: SCHC ) is developed small capitalization equity. The Schwab U.S. REIT ETF (NYSEARCA: SCHH ) is domestic equity REITs. The Schwab U.S. Aggregate Bond ETF (NYSEARCA: SCHZ ) is a remarkably complete bond fund. is a long term treasury ETF. The PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF (NYSEARCA: ZROZ ) is an extremely long term treasury ETF. Notice that the 3 international equity ETFs have only been weighted at 5% while the broad market index has been weighted at 25%. I find heavy exposure to international equity to bring more risk than expected returns so I try to keep my international exposure low. I prefer no more than 20% in international equity. Plenty of domestic companies already have enormous international operations so the benefit of international diversification is not as strong as it would be if the markets were isolated from each other. Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. When TLO and ZROZ post negative risk contribution it is because the negative correlation to most of the equity holdings results in the long term treasury ETFs reducing the total portfolio risk. In my opinion, this is the best argument for including them in the portfolio. Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio and with the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ). 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 TLO and ZROZ post fairly similar numbers on negative correlations and if I was simply using the ETF for producing some income it would be easy to select TLO over ZROZ. On the other hand, because the correlations are so negative, higher volatility in the ETF can become an attractive feature. The quickest way to demonstrate this factor is to look at the negative beta for each ETF. On TLO the beta is a negative .49 and on ZROZ the beta is a negative .90. TLO is a good option with rebalancing to make a steadier portfolio value. For the simple purpose of stabilizing portfolio values I think ZROZ a quicker way to accomplish my goal because I can use a smaller allocation to the bond ETF to maintain the negative beta exposure that reduces the overall volatility of my portfolio. If an investor wants more bond allocations, then I think they should start with diversified exposure like SCHZ and then look to add TLO before adding ZROZ. If the goal is simply creating negative beta for the portfolio, the order of the ETFs would be reversed with investors favoring ZROZ, then TLO, and finally SCHZ. Disclosure: I am/we are long SCHB, SCHD, SCHF, SCHH. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.