A Bond-Fund ETF That Should Hold Up Well as Interest Rates Rise

Once interest rates begin to rise meaningfully—and yes, they will someday—prices of most bonds and the funds that own them will come under pressure. One Kiplinger ETF 20 member that should stay afloat is PowerShares Senior Loan Portfolio (BKLN). The exchange-traded fund boasts a 5.5% yield, well above the 2.3% average for investment-grade U.S. bonds.

PowerShares holds loans made by banks to heavily indebted firms with poor credit ratings. These junk-rated borrowers are charged “floating” interest rates that are typically tied to a short-term benchmark: the London Interbank Offered Rate, or LIBOR. When LIBOR rises above a certain level, rates on these loans bump up, helping them hold their value better than bonds. Between June 29, 2004, and June 29, 2006, the last period during which the Federal Reserve was lifting short-term rates, the bank-loan market gained a total of 5.8%, according to investment firm Lord Abbett. The bond market, as measured by the Barclays U.S. Aggregate Bond index, earned 3.1% over that period. (Though bond prices and rates move in opposite directions, the Barclays index was in the black because interest payments more than offset declines in bond prices.) Another plus for bank loans: If a borrower defaults, the bank gets paid ahead of bond- and stockholders.

But that doesn’t mean nothing can go wrong. Although this ETF should hold up well as rates rise, it comes with other risks you shouldn’t overlook. The main concern is that the $836 billion loan market sits on a tinderbox of shaky balance sheets. In 2008, floating-rate bank loan prices collapsed by an average of 32% as the default rate on loans approached 10%. Defaults are now running at a rate of 1.3%. But the number of loans to firms with weak finances has risen sharply in recent years, and it’s getting harder for these businesses to “maintain their debt burdens,” says Christopher Graff, director of asset management at RMB Capital Management in Chicago.

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Moreover, when the Fed finally begins to raise short-term rates (likely in the fourth quarter of 2015), the yield on the PowerShares ETF probably won’t budge. Loans in the index it tracks have an average interest rate “floor” of about 1%. That means short-term rates, currently near 0%, would have to rise above that level for a loan’s rate to reset higher. Assuming that the Fed raises rates at a gradual pace, it would likely take another year for that to happen, says Zane Brown, a fixed-income strategist with Lord Abbett.

So despite the potential dangers, we continue to recommend the PowerShares ETF, which we think provides a reasonable trade-off between current income and risk. If the U.S. economy continues to expand moderately—Kiplinger forecasts 2.8% growth in 2016—default rates should stay low. And if interest rates do edge up, the ETF should hold its value.