LONZ ETF: High Yield Leveraged Loans (NYSEARCA:LONZ)

I recently came across the PIMCO Senior Loan Active Exchange-Traded Fund (NYSEARCA:LONZ) while researching high yield investments.

LONZ ETF is an actively managed fund focused on the leveraged asset class. While LONZ has overcome passive leverage credit ETF, the outperformance appears to be the result of LONZ’s lower credit quality investments and higher leverage.

Looking ahead, with rising unemployment and an economic slowdown on the horizon, investors may want to move their high-quality portfolios away from the non-investment grade leveraged loans held in LONZ’s portfolio. Investment CLO ETFs can be viable alternatives, paying similar yields with better credit quality.

Fund overview

The PIMCO Senior Loan Active Exchange-Traded Fund is a recently launched ETF from the fixed income experts at PIMCO that targets the bank credit asset class.

Bank loans, also known as senior loans or leveraged loans, are variable rate debt securities issued by companies with less than clean credit history. Historically, these loans were made by banks, hence term bank loans, although in recent years, many non-bank entities such as hedge funds have extended leveraged loans to companies.

The LONZ ETF invests primarily in an actively managed portfolio of U.S. leveraged loans and collateralized loan obligations (“CLOs”). CLOs are synthetic securities constructed from the securitization of baskets of leveraged loans.

The LONZ ETF has $541 million in assets (Figure 1) and charges an adjusted expense ratio of 0.60% (fee-free through October 2025; reverts to 0.72% thereafter).

Portfolio holdings

Looking through the fund’s disclosure, we see that the LONZ ETF has a 30-day SEC yield of 6.5% while paying a distribution yield of 6.7% (Figure 2).

The fund holds 328 securities, 86% of the portfolio allocated to bank loans, 3% allocated to bonds and 26% allocated to “Other” securities, which probably means CLOs (Figure 3). The LONZ ETF also has a -15% allocation to other short-duration instruments, meaning the fund has internal lever.

In terms of credit quality, the majority of LONZ’s portfolio is rated non-investment grade (CCC-to BB-rated), with 8.7% allocated to BB-rated securities, 53.7% allocated to B-rated securities, 1.5% CCC and 35.1% unrated.

Performance

In terms of historical performance, the LONZ ETF has done well since its inception in June 2022, returning 13.0% in 2023 and 10.4% on a 1-year basis through July 31, 2023 (Figure 4). Since inception, the fund has posted average annual returns of 8.7%.

LONZ vs BKLN

However, it’s hard to look at LONZ’s performance in isolation, as a fund can deliver strong returns through excessive risk-taking or leverage. To assess whether the fund manager has added “alpha”, I usually like to compare the performance of a particular fund against the passive ETFs that represent its asset class.

For the LONZ ETF, I think a suitable passive ETF for comparison is the Invesco Senior Loan ETF (BKLN). The BKLN ETF tracks the investment performance of the Morningstar LSTA US Leveraged Loan 100 Index (the “Index”) and is the largest passive ETF targeting the leveraged asset class.

Figure 5 shows the credit quality allocation by BKLN. We can see that compared to the LONZ ETF, the BKLN ETF has a higher credit quality, with 10.7% of the portfolio rated BBB (compared to 0.8% for LONZ), 36.7% with rating BB (vs. 8.7%), 49.5% Rated B (vs. 53.7%) and only 3.2% rated CCC or unrated (vs. 36.6% for LONZ).

Comparing LONZ to BKLN, LONZ outperformed on a 1-year basis, returning 9.6% versus BKLN’s 8.9% (Figure 6).

Since inception, LONZ has returned 19.8% compared to 18.6% for BKLN (Figure 7).

While LONZ has historically outperformed BKLN, we must consider that LONZ’s portfolio is of considerably lower quality (lower credit ratings) and LONZ uses leverage. Adjusted for leverage, LONZ may not have outperformed.

For example, if we model a portfolio that is long 115% BKLN while short 15% the iShares 0-3 Month Treasury Bond ETF (SGOV) (roughly a 15% leveraged long position in BKLN), we can see that the performance of this model portfolio since the beginning of LONZ is practically identical to that of the LONZ ETF (Figure).

Consider CLOs instead of bank loans

Additionally, given the credit quality of LONZ’s portfolio, I recommend investors look at alternative floating rate funds such as the Janus Henderson AAA CLO ETF ( JAAA ) or the Janus Henderson B-BBB CLO ETF ( JBBB ).

JAAA holds a portfolio of collateralized loan obligations (“CLOs”) rated AAA, while JBBB holds CLOs rated BB-B. To understand why CLOs can be better than leveraged loans, we must first understand the structure of CLOs and the securitization process.

As briefly mentioned above, CLOs are securities created from baskets of underlying leveraged loans. Through a securitization and tranching process, CLO managers create synthetic high-rated investment-grade securities (rated BBB to AAA) from non-investment-grade leveraged loans (Figure 9).

Investment-grade CLO debt tranches are protected from credit losses by structural enhancements such as over-collateralization and embezzlement of interest. Overcollateralization means that the CLO manager can pool $120 million in loans to create $100 million in debt securities, plus $20 million in equity securities. When credit obligations occur in this portfolio, the security’s senior debt tranches (i.e., AAA) are protected against default by the equity tranches and junior debt tranches (i.e., the “equity” tranches own” take the first loss, followed by CCC, B., BB etc.).

Interest diversion means that senior debt tranches take priority over cash flows collected from the loan pool (ie AAA tranches are paid with interest first, followed by AA, etc.).

Because of these structural improvements, CLOs have historically experienced very few defaults, even through the Great Financial Crisis of 2008 (Figure 10).

Comparing the LONZ ETF to BKLN, JAAA and JBBB, we can see that the Janus Henderson CLO funds also charge significantly lower expenses (Figure 11).

Additionally, in terms of credit quality, the JAAA and JBBB ETFs hold significantly higher quality portfolios, with 97.8% of the JAAA portfolio rated AAA, while 97.7% of the JBBB portfolio is rated BBB or more (Figure 12).

Even though the credit quality is better, the JBBB ETF has historically outperformed the LONZ ETF, returning 21.0% since LONZ’s inception in June 2022 (Figure 13).

Beware of a slowing economy

In recent months, I have written several articles warning of a slowing economy. In my personal view, with unemployment rising rapidly from cycle lows (Figure 14) and the Federal Reserve preparing to begin an easing cycle in the coming months, investors should take the opportunity to reassess their portfolios .

Instead of chasing the LONZ ETF’s 7.6% distribution yield, a better alternative might be to short a 6.4% yield from JAAA, which holds mostly AAA-rated securities (Figure 15) .

While the LONZ ETF has certainly outperformed the June 2022 JAAA, this is largely due to the tightening of high-yield credit spreads, which have collapsed from nearly 6% in July 2022 to 3.2 % currently (Figure 16).

If the economy were to continue to weaken in the coming quarters, credit spreads would inevitably widen and negatively impact the non-investment grade leveraged loans in LONZ’s portfolio.

Conclusion

The LONZ ETF is an actively managed portfolio of leveraged loans and other floating rate securities. Historically, the LONZ ETF has outperformed the passive BKLN ETF. However, I believe LONZ’s outperformance is largely due to the manager’s modest internal leverage and the higher credit risk in its portfolio. Adjusted for leverage, LONZ’s performance is virtually identical to the passive BKLN ETF.

With a possible economic slowdown on the horizon, I recommend investors put their portfolios high. Instead of the LONZ ETF, investors may want to consider CLO ETFs like the JAAA or JBBB ETFs, which have structural credit enhancements to protect investors. I rate LONZ a YOU.