Bank loan, or senior loan, exchange traded funds became a favored asset class for yield-starved investors in recent years, but more recently, well-known bank loan ETFs have suffered outflows as some investors have voiced concerns regarding the underlying liquidity in the senior loan market.
Additionally, some market observers see tighter regulations as potentially crimping the senior loan market. For example, U.S. regulators, including the Federal Reserve and the Office of the Comptroller of the Currency, have revealed new guidance to govern banks’ leveraged lending to contain a potentially overheated credit market. The Fed also confirmed that it will incorporate the guidance in its annual stress test for banks, which would diminish a failing bank’s ability to pay dividends to shareholders. [New Regulations Could Weigh on Bank Loan ETFs]
Still, ETFs such as the PowerShares Senior Loan Portfolio (NYSEArca: BKLN) hold allure for investors, particularly at a time when high-yield energy debt is mostly viewed as unattractive in the face of low oil price and when it is nearly a foregone conclusion that the Federal Reserve will raise interest rates later this year.
Since the senior loans have rates that adjust periodically, the floating-rate loans offer investors an alternative method of earning yields with little or no interest-rate risk. Due to their floating rate component, bank loans are seen as an attractive alternative to traditional 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. The $5.43 billion BKLN has an average days to reset of 23.3 with a yield to maturity of 4.82%. [Rising Rates Have Bank Loan ETFs in Focus]
“In a rising rate environment, bank loans have a key advantage over traditional high yield bonds — they are structured with floating rates. This allows their coupons to adjust upward as rates rise, and makes them a potentially attractive source of yield to consider in a rising rate environment. As investors focus on the interest rate exposure of their fixed income investments, bank loans may offer a lower sensitivity to interest rate risk thanks to their lower duration, while providing the potential for attractive income,” said PowerShares Director of Fixed Income Strategy Scott Eldridge in a recent note.
Eldridge also points out that bank loans are typically less exposed to the energy sector than traditional high-yield bonds, a positive trait at a time when fears are still running high that low oil prices with force a spate of defaults among highly leveraged exploration and production companies. [Energy Warnings for Junk Bond ETFs]