Yield-hungry investors should look beyond the usual asset classes in their quest for income and that includes considering bank loans or senior loans, an asset class available several exchange traded funds, including the PowerShares Senior Loan Portfolio (NYSEArca: BKLN) and the Highland Capital Management’s senior loan ETF (SNLN).
A senior loan is a private loan a firm takes from an underwriting bank or a syndicate of lenders. The loans are also secured in that they are backed by the borrowers’ assets, which act as collateral. If the borrower defaults, lenders have a senior claim on the defaulters’ assets.
Senior secured floating-rate loans have, as their name suggests, a floating interest rate component, which fluctuates with market rates. Because rates are typically reset once per quarter, senior loans typically have low durations. Since the senior loans have rates that adjust periodically, the floating-rate loans also offer investors an alternative method of earning yields while mitigating interest-rate risk. BKLN, the largest ETF tracking this asset class, has a reset period of almost 28 days.
While senior loans are rated below-investment grade, default rates on senior loans have historically been slightly below those of high-yield or junk bonds. Additionally, in the event of a default, investors are more likely to recoup losses, which may make the asset category less risky than high-yield, speculative-grade debt.
“One of the advantages of these floating rate securities is that coupon floors exist so as rates fall investors still receive respectable income. However, as interest rates rise, the commensurate coupon rate can also rise, which can increase the mark-to-market value of the security. Lastly, the effective duration is typically tied to the security’s reset rate, which is typically no longer than 60-90 days,” according to a Seeking Alpha analysis of senior loans.
Senior loans do not come with a maximum settlement period, which may cause trouble for funds that try to redeem senior loans during more volatile periods. Fund providers, though, may stick to more liquid segments of the senior loan market and hold cash to help offset this risk.
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