Increase your earnings and your capital will be nibbled. How to evaluate the compromise.

“I bought the Invesco Senior Loan ETF, ticker symbol BKLN, in 2017 and have not seen the light of day since. I bought it when I found out that it has a floating rate and shouldn’t lose value as interest rates rise. Any advice considering the likelihood of interest rates rising around the corner? I’m thinking of selling. Should I?”

Said, Arabia

My answer:

You are disappointed. You had in mind that your fixed income investment would combine high returns with low capital risk. Unfortunately I have to inform you that this combination is not possible.

This point can be rephrased: There is no such thing as a free lunch in investing.

Over the past decade, your fund has combined a high return with a modest capital loss. The bottom line is a decent total return. If we get steadily rising interest rates over the next ten years, the fund could well suggest alternative ways to collect interest rates.

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

Someone lending money, which you do if you own that fund, is potentially taking two risks. One is that interest rates could rise, which would lower the value of a fixed-income stream. The other risk is that you won’t get your money back.

Senior loan funds all but eliminate the first risk since these loans have variable interest rates. They don’t eliminate the second risk. In fact, most of the time, the loans go to heavily indebted junkie companies, and sometimes junkie companies go bust. You can lose capital.

The Invesco fund came to market 11 years ago with a starting price of $25 per share. In the 2020 pandemic crash, shares tumbled, almost touching the $17 mark. They have recovered to $21. Since you probably paid something close to $23, hurt.

Don’t judge Invesco. It has delivered exactly what it promised its clients: an adjustable rate fund that pays better interest than you could get on a money market fund, but suffers from capital falls at times.

“Senior Loan” is Wall Street lingo for a security that looks and behaves like a corporate bond, except it usually has an interest rate that resets about every month, usually by a company with a weak balance sheet is issued, often is illiquid and often backed by specific collateral. The security means the loan has some residual value if an issuer goes under the waves. Nevertheless, the principle is being eroded.

What you have in effect is a junk money market fund. Is it a bad deal?

You should put this exchange-traded fund in the context of other ETFs that hold fixed income assets. As mentioned above, there are two dimensions of risk, credit risk and price risk. You may be exposing yourself to one or both of these risks. Risk takers are rewarded with higher returns. Occasionally they are also insulted with a price drop.

Imagine a 2×2 array. In the safe bottom left corner is a fund that has no credit or interest rate risk: the Vanguard Short-Term Treasury ETF (VGSH). The credit quality is AAA. The price risk, as measured by duration, is 1.9 years, which means that the price of shares in the fund is as sensitive to changes in interest rates as a zero-coupon bond with a maturity of 1.9 years.

In the top left corner: the Vanguard Total Bond Market ETF (BND). It owns mostly government bonds, so its credit quality, as reported by Morningstar, is AA, almost as good as the Treasury fund’s quality. But with a duration of 6.8 years, the price risk has more than tripled.

Bottom right: Your senior loan fund. Its duration of 0.1 years means it is immune to rate hikes, just like you were told when you bought it. But the credit quality is pretty bad. Morningstar gives it a B, two steps into junkdomie.

Above right: the 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.

All four funds have experienced some capital erosion over the past decade. The falls ranged from 1.6% for the safest of the group, invested in short-dated government bonds, to as much as 15% for the junk bond fund.

But the loss of capital is tolerable when accompanied by a hefty coupon. 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 for short government bonds was at the other end of the spectrum at 0.9% per year.

In between, returns landed for the other two funds. BND (high credit quality, long maturity) averaged 2.3% per year. Your fund (low quality, short duration) averaged 2.9%.

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

Their junk money market has an SEC yield of 3.1%. Factor in credit losses and you really earn 2% or less.

In addition to defaults, corporate loans come with hidden option costs. The issuer usually has the right to repay the debt early. She will exercise this option if interest rates fall or if her finances improve. When interest rates rise and financial conditions deteriorate, you’re stuck with bad paper. You lose tails, you break heads balanced. It’s hard to quantify the implicit option built into corporate bonds, but it likely cuts your expected yield by a quarter point or more.

If you knew that the next decade, like the previous one, will bring a strong economy and subdued inflation, risk-taking JNK would be your best bet. A weak economy with low inflation would make the BND the winner. Your BKLN would be nice if the economy holds up and the Fed continues to print money with gusto. Short-dated government bonds are the way to go if stagflation is our destiny.

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

Do you have a personal finance conundrum that might be worth checking out? This can be, for example, pension lump sums, estate planning, employee options or pensions. Send a description to williambaldwinfinance—at—gmail—dot—com. Type “search query” in the subject field. Enter a first name and a state. Add enough detail to create a useful analysis.

Letters are edited for clarity and brevity; only a few are chosen; The answers are intended to be educational and do not replace professional advice.

More in the “Reader Asks” series:

What is the risk of being double crossed if I delay Social Security?

Should I pay off my mortgage?

Should I invest all my bond money in TIPS?

Directory of Reader Ask columns