With the Federal Reserve expected to tighten its monetary policy soon, investors can utilize floating-rate, high-yield, senior loan exchange traded funds to hedge against a rising interest rate environment.
“With rates that adjust periodically, floating-rate loans offer investors an alternative method of earning higher yields with little or no interest-rate risk,” Ethan Powell, Highland Capital Management’s chief product strategist, said in a Wall Street Journal article. “Even though the loans are issued by below-investment-grade corporations, they have seniority over other forms of equity and debt in the event of default.”
Powell suggests investors should look at ETF options as a way to access this specific area of the fixed-income space. For instance, the Highland/iBoxx Senior Loan ETF (NYSEArca: SNLN) provides access to the senior bank loans market.
Due to their floating rate component, bank loans are seen as an attractive alternative to traditional high-yield corporate bonds in a rising rate environment. Bank loan securities allow their interest rate to shift, or float, along with the rest of the market, whereas a fixed interest rate stays constant until maturity.
Specifically, SNLN’s floating component typically takes an average 21.2 days to reset, providing the bank loan securities with a negligible effect from rising rates, and the ETF offers a 5.04% 30-day SEC yield. In comparison, a high-yield bond ETF, like the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEArca: HYG), has a 4.07 year effective duration – a 1% increase in the interest rate could translate to a 4.07% decline in HYG’s price – and comes with a 4.67% 30-day SEC yield.
Investors, though, should not forget that senior bank loans are denoted high-yield because the issuing firms are highly leveraged, and highly leveraged companies are more at risk of default and bankruptcy. Nevertheless, these bank loans are slightly safer than traditional high-yield bonds since they are secured by collateral and have historically shown lower default rates.