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How to Get More Than 4%, While Protecting Against Principal Loss

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Senior bank loan securities, which are available in an ETF, offer benefits that not all investors are aware of.

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Investors have been trying to get higher rates of returns for years now, while at the same time worrying about capital loss in their fixed income securities if and when interest rates start climbing up, which they at some point will. Money has poured into bond funds. In 2012, high-yield bond funds added substantial amounts of new money, and emerging markets bond funds did also. One segment of the fixed income market that did not receive much in the way of new assets is the bank loan debt funds. Bank loan debt funds attracted very little in new assets in 2012.

As investors look for higher rates of return while also wanting to hedge against principal loss, they should know about the advantages of senior bank loan securities, and that these types of securities are available in an ETF. Senior floating-rate bank loans are senior secured debt instruments that are issued with variable rates by non-investment-grade companies. The rate on senior bank loans reset every 30 to 90 days. The rate is a fixed-percentage spread over a floating base rate, usually the London Interbank Offered Rate (Libor). Bank loans are considered the most senior security in the capital structure universe because bank loans are secured by collateral of the company making the loan. A company could pledge as collateral its assets such as its equipment, its real estate, or its accounts receivable. Bank loans are similar to high-yield debt but could be considered safer because the secured collateral gives the investor a level of protection in case of a loan default.

In a rising-rate environment, bank loans tend to outperform fixed-rate securities. Of course, investors are aware of this, which is why retail asset flows for the sector increase during these periods. What is not as well understood is that, in a flat-rate environment, bank loans also outperform the broad bond benchmark. The main reason for the outperformance is the yield advantage that the bank loans provide over the Barclays index. In today's market, the Barclays index has a current yield to maturity of only 2.5%, which gives the bank-loan index a yield advantage. If we stay in the current flat-yield environment, bank loans look very attractive.

Risks

One of the biggest risks to bank loans is the potential for a US recession in the near future. While a recession is not expected by the Federal Reserve and many economists, factors such as the ongoing political war over taxes and spending could push the United States into a recession if Congress doesn't come to a compromise on future tax rates. A recession would increase defaults for the bank loan sector, which would depress the prices of loans. However, some data show that bank loans have positive performance even during recessions. The only year that bank loans posted a negative return in a recession was 2008, when the bank loan sector lost 29%. Much of that loss was due to the issuance of loans in the leveraged buyout boom of 2006 and 2007. Current bank loans are being issued with a conservative risk profile, one that is more typical of the period before 2006. The highly leveraged investors who drove much of the market volatility have not returned. While a recession will hurt, the bank-loan market looks better prepared today and may even post positive returns in the next recession.
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Max Isaacman and/or customers own shares of BKLN.
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