As the markets anticipate a higher likelihood of a Federal Reserve interest rate hike before the year’s end, it may be a good time to revisit senior floating-rate bank loans exchange traded fund strategies.
A Senior loan is a private loan a firm takes from a bank or a syndicate of lenders. The loans 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.
“The correlation of bank loans has been historically and consistently low versus other asset classes through different credit and rate cycles,” according to Highland Capital Management.
[related_stories]Moreover, senior loans have a floating interest rate, which fluctuates with market rates. Because rates are typically reset once per quarter, senior loans come with 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, due to their floating rate component, bank loans are seen as an attractive substitute to traditional corporate bonds in a rising rate environment.
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“Bank loans offer the potential for higher yield over other traditional fixed income products, and could be considered a defensive allocation given the security interest in assets pledged by the borrower against the loan,” according to Highland. “Adding a defensive allocation is timely and should be a priority for investors heading into the next phase of the credit cycle, especially given the recent rally in unsecured high yield bonds.”
For example, the PowerShares Senior Loan Portfolio (NYSEArca: BKLN), the largest senior loan-related ETF on the market, has an average 46.99 day to reset period – the average number of days until the floating component of the loans reset. The ETF also comes with an attractive 5.95% 30-day SEC yield.
Along with BKLN, investors may look to the passive index-based Highland/iBoxx Senior Loan ETF (NYSEArca: SNLN). SNLN has a 30.8 days to reset and a 4.6% 30-day SEC yield.
There are also two actively managed options, including the SPDR Blackstone/GSO Senior Loan ETF (NYSEArca: SRLN), which has a 47 days reset period and a 3.85% 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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Moreover, bank loans look relatively cheap despite the recent rally in riskier assets. Year-to-date, the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEArca: HYG) rose 10.1% while BKLN gained 6.5%, SNLN increased 5.7%, SRLN added 4.2% and FTSL returned 5.4%. These senior bank loan ETFs could outperform once markets start pricing in a rising rate outlook.