Wall Street is famous for creating new products. Sometimes, these products prove to be disastrous, like derivatives on subprime mortgages were in 2008.
At other times, new products turn out to be beneficial to individual investors. Exchange-traded funds (ETFs) are an example of a Wall Street innovation that helped individual investors. Assets in ETFs topped $1.6 trillion in October, and individual investors have more than 1,250 funds to invest in.
The vast number of ETFs serves two purposes. First, a large number of investment options provides individual investors with an opportunity to diversify their portfolio. Second, it provides a way for fund sponsors to maximize their potential revenue by having products that appeal to almost all investors.
This second purpose, generating fees, has led to some funds with objectives that are not suitable for most investors. Many leveraged funds fit into this category. On the other hand, the drive to generate fees has led firms to offer ETFs that provide individual investors with access to markets that are not available to them otherwise.
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Senior loans are an example of one investment that market individual investors cannot access without an ETF.
Senior loans are generally made to companies with credit ratings that are below investment grade. In this way, they are similar to high-yield, or junk, bonds. While there are similarities to junk bonds, senior loans also offer several advantages over junk bonds.
Senior loans are senior to all other debt when the loan is made, which means it is more likely to be repaid if a borrower enters bankruptcy. Senior loans also have variable interest rates, which means they will react quickly to market conditions if interest rates rise and limit investor losses in that environment.
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Some borrowers will use senior loans to finance acquisitions, while others may use them to refinance debt that is maturing. This has been a private market where the loans are negotiated between the lender, which is a bank or other financial institution, and the borrower. Loans are often syndicated so several banks or financial institutions can participate in the deal.
Since 2011, individual investors have been able to participate in the senior loan market through PowerShares Senior Loan Portfolio (NYSE: BKLN). This ETF now has more than $6 billion in assets, a little more than 1.1% of the estimated $540 billion market for these loans.
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Among the fund's largest holdings are senior loans being repaid by companies like Heinz and Chrysler. BKLN's loans carry an average interest rate of 4.14% and the rates reset, on average, every 32 days, which means investors face small risks if rates rise because the interest payments will quickly increase to keep up with rising rates.
Action to Take --> BKLN pays a monthly dividend and offers investors a yield of about 4.5%. The ETF has very low volatility with the difference between the 52-week high and low being about 3.3% of the average price. For investors considering a short-term certificate of deposit or a Treasury bill, BKLN could be an attractive alternative.
This article originally appeared at ProfitableTrading.com:
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