Bank loan, or senior loan, exchange traded funds have garnered an impressive following in recent years due to attractive yields and the funds’ ability to remain durable in rising interest rate environments. However, understanding how those yields and interest durability are delivered are important considerations.
One way of looking at bank loans is that they are floating rate products because the rates on the loans are reset every month or two months. That helps keep duration low. The current market environment seems to be right in bank loan ETFs’ wheelhouse as investors clamor for income while also guarding against the negative impact of rising rates.
“The first thing to understand about the floating-rate nature of bank loans is that their yields “float” along with Libor (the London Interbank Offered Rate), not the more widely watched 10-year Treasury yield or federal-funds rate. Libor represents the rate at which the major banks can borrow from each other in the London interbank market over various time periods, ranging from overnight to one year,” according to a recent Morningstar note.
The $5.7 billion PowerShares Senior Loan Portfolio (NYSEArca: BKLN) has a three-month LIBOR rate of 0.28% as does the $678.3 million SPDR Blackstone/GSO Senior Loan ETF (NYSEArca: SRLN). [Bank Loan ETFs Back in Style]
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.
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. [Enduring Appeal 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
