Ins and outs of Bank Loan ETFs

Though rate resets in ETFs such as BKLN and SRLN are easy to understand, there are other considerations to take into account.

“An often overlooked feature included in the term structure of most bank loans is what’s called an interest-rate floor. Consider the bond used in the previous example. If Libor fell to 0.5% and there was no interest rate floor, then the expected interest payment on the loan would be 4.5%. However, if that loan was issued with an interest rate floor of 1.0%, then its interest payment would reset to 5.0%. In this case, Libor dipped below the interest-rate floor, so rather than Libor plus the spread, the interest payment becomes the interest-rate floor plus the spread,” according to Morningstar.

Bond funds with long durations will pull back as interest rates rise. Investors should be aware that they are still exposed to credit risk as the majority of underlying bank loan holdings are rated speculative-grade or junk.

“Bank loans are likely to prove their worth if there is a sustained increase in Libor and it increases above the typical floor of 100 basis points. These funds may therefore still have a role to play for investors who are concerned about rising rates and are willing to tolerate the imbedded credit risk in these loans,” notes Morningstar.

SPDR Blackstone/GSO Senior Loan ETF