What do you think of my junk money market?

Increase your yield and your principal is nibbled away. Here’s how to assess the trade-off.

“I bought the Invesco Senior Loan ETF, ticker symbol BKLN, in 2017 and haven’t seen the light of day since. I bought it when I found out it was floating rate and if interest rates rise, it shouldn’t lose value. Any advice, given the likelihood of an imminent rate hike? I’m thinking of selling. Should I?”

Saed, Arabia

My answer:

You are disappointed. You thought your fixed income investment would combine high return with low capital risk. I regret to inform you that this combination is impossible.

This point can be rephrased: there is no free lunch in investing.

Over the past decade, your fund has combined high performance with modest principal damage. The bottom line is a decent total return. If we get steadily rising rates over the next decade, the fund may well beat other means of earning interest.

The short answer to your question is that you shouldn’t be in a rush to sell. The longest answer:

Someone lending money, which you do when you hold that fund, is potentially taking two risks. The first is that interest rates could rise, reducing the value of a stream of fixed income securities. The other risk is that you won’t get your money back.

Senior loan funds pretty much eliminate the first risk because these loans have floating interest rates. They do not eliminate the second risk. Indeed, the loans are mainly granted to junky companies, highly indebted, and sometimes junky companies go bankrupt. You can lose the principal.

The Invesco fund came out 11 years ago with a starting price per share of $25. In the pandemic crash of 2020, stocks sank, hitting almost $17. They recovered at $21. Since you probably paid something close to $23, you are suffering.

Don’t condemn Invesco. He delivered exactly what he promised his clients: a floating rate fund that pays better interest than you might get on a money market fund, but suffers from occasional capital hits.

“Senior Loan” is Wall Street lingo for a security that looks and acts like a corporate bond, except it usually has an interest rate that resets every month or so, is usually issued by a company with a weak balance sheet, is often illiquid and is often backed by specific guarantees. Collateral means that when an issuer sinks under the waves, the loan has some salvage value. Yet the principal is eroding.

What you have, in effect, is an unwanted money market fund. Is this a bad deal?

You should put this exchange-traded fund in the context of other ETFs that hold fixed-income assets. As stated above, risk has two dimensions, credit risk and interest rate risk. You may expose yourself to either or both of these risks. Risk takers are rewarded with improved returns. They also get bombarded on occasion with lower prices.

Imagine a 2×2 array. In the safe corner, bottom left, is a fund with little exposure to credit or interest rate risk: the Vanguard Short-Term Treasury ETF (VGSH). Credit quality is AAA. The interest rate risk, measured by duration, amounts to 1.9 years, which means that the price of fund units is as sensitive to changes in interest rates as a zero-coupon bond maturing in 1.9 years.

Top left: Vanguard Total Bond Market ETF (BND). It holds mostly government paper, so its credit quality, as reported by Morningstar, is AA, almost as good as the quality of the Treasury fund. But with a duration of 6.8 years, it more than tripled the interest rate risk.

Bottom right: your senior loan fund. Its 0.1 year term means it’s immune to rate hikes, as you were told when you bought it. But the credit quality is pretty abysmal. Morningstar gives it a B rating, two not junkdom.

Top right: SPDR Bloomberg High Yield Bond ETF (JNK). You get a double dose of risk from junk bonds. The fund’s portfolio has a B credit rating and a duration of 3.8 years.

Over the past ten years, all four funds have experienced some erosion of principal. Share price declines ranged from 1.6% for the safest of the bunch, invested in short-term Treasuries, to 15% for the junk bond fund.

But the loss of capital is tolerable if it is accompanied by a significant reduction voucher. Over the past decade, this junk bond fund has had the best total return (coupons minus price erosion), at 4.2% per year. The total return on short-term Treasuries was at the other end of the spectrum at 0.9% per year.

The returns of the other two funds landed in between. BND (high credit quality, long duration) averaged 2.3% per year. Your fund (low quality, short duration) shows an average of 2.9%.

What about today’s returns? You can look at them, but they don’t give you a fair idea of ​​expected returns. The junk bond fund has a yield, as defined by the Securities & Exchange Commission, of 5.6%. But this yield figure does not include a provision for loan losses. If that were the case, the yield would likely shrink to a number below 3%.

Your junk money market is showing a SEC yield of 3.1%. Factor in loan losses and you really earn 2% or less.

In addition to loan losses, corporate credit comes with a hidden opportunity cost. The issuer generally has the right to prepay the debt. She will exercise this option if rates go down or her finances improve. If rates go up and his financial situation deteriorates, you’re stuck with the wrong paper. Heads you lose, heads you break even. The implicit option embedded in corporate debt is hard to put in a number, but it probably cuts your expected return by a quarter of a point or more.

If you knew that the next decade will offer, like the previous one, a strong economy and moderate inflation, the risk on JNK would be the best bet. A weak economy with low inflation would make BND the winner. Your BKLN would be fine if the economy holds up and the Fed continues to print money with abandon. Short-term Treasuries are the thing to have if stagflation is our destiny.

If you don’t know what the future holds, spread your bets. My advice is to keep some of the equity in your loan fund, but move some of the money into other types of fixed income securities.

Do you have a personal finance puzzle that might be worth a look? These may include, for example, lump sum retirement payments, estate planning, employee options or annuities. Send a description to williambaldwinfinance—at—gmail—dot—com. Put “Request” in the subject field. Include a first name and state of residence. Include enough detail to generate useful analysis.

Letters will be edited for clarity and conciseness; only some will be selected; the answers are intended to be educational and are not a substitute for professional advice.

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