ETF Trends | Senior Bank Loans: An Alternative Fixed-Income ETF Strategy

By August 5, 2016August 19th, 2016In the News

Yield-strapped investors seeking to augment their income should consider incorporating senior secured floating-rate bank loans and related exchange traded funds into their portfolios.

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.

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.

“Companies typically pledge all tangible and intangible assets against loans,” Chris Mawn, Portfolio Manager of Highland Capital Management’s senior loan ETF (SNLN), told ETF Trends. “As a result, loans have historically achieved default recoveries twice those of high-yield bonds. High-yield bonds also experience greater dispersion than loans in default recoveries.”

Junk bonds have, however, performed well over recent months, which is largely attributable to interest-rate movements that resulted in relative underperformance of senior floating-rate loans. Year-to-date, the BofA Merrill Lynch US High Yield Index rose 11.8% while the S&P/LSTA U.S. Leveraged Loan 100 Index gained 7.1%. Consequently, Mawn argued that high-yield bonds may be overbought relative to senior loans and therefore more susceptible to a pullback.

“The relative value in senior secured loans compared to high yield is attractive to us right now,” Mawn said.

Moreover, 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. Consequently, bank loans are seen as an attractive substitute to traditional corporate bonds in a rising rate environment.

Looking ahead, as investors face a number of potential headwinds including slower global growth, continued commodity price volatility and central bank policy uncertainty, Mawn believes the U.S. could prove to be a relative outperformer. According to Mawn, a slow growth economic scenario in the U.S. may still prove constructive for corporate credit, while more challenging for equity valuations.

“We expect the current low GDP growth environment will increase the appeal of predictable yields provided by the bank loan market,” Mawn added. “Credit can outperform with slow and steady GDP growth.”

Mawn pointed to loan performance over the last two decades as evidence of this, as loans only experienced two negative years in that timespan.

ETF investors interested in gaining exposure to the senior bank loan market have a number options to choose from. For example, the PowerShares Senior Loan Portfolio (NYSEArca: BKLN), the largest senior loan-related ETF on the market, has an average 44.2 day to reset period – the average number of days until the floating component of the loans reset. The passively managed ETF is based on the S&P/LSTA U.S. Leveraged Loan 100 Index, which is designed to track the market-weighted performance of the largest institutional leveraged loans. The fund also comes with a 0.65% expense ratio and an attractive 5.86% 30-day SEC yield.

Along with BKLN, investors may look to the passive index-based Highland/iBoxx Senior Loan ETF (NYSEArca: SNLN). SNLN tracks the Markit iBoxx USD Liquid Leveraged Loan Index, which consists of the largest, most liquid leveraged loans. SNLN has 30.8 days to reset and a 4.83% 30-day SEC yield. It offers a 0.55% expense ratio.

There are also two actively managed options, including the SPDR Blackstone/GSO Senior Loan ETF (NYSEArca: SRLN), which has a 48 days reset period and a 3.89% 30-day SEC yield, and First Trust Senior Loan ETF (NasdaqGM: FTSL), which has a 52.29 days reset period and a 3.87% 30-day SEC yield.

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