Senior Bank Loans An Alternative Fixed-Income ETF Strategy

Yield-strapped investors seeking to augment their income should consider incorporating senior secured floating-rate bank loans and related exchange traded funds into their portfolios.

A senior loan is a private loan a firm takes from an underwriting bank or a syndicate of lenders. The loans are also secured in that they 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. Additionally, in the event of a default, investors are more likely to recoup losses, which may make the asset category less risky than high-yield, speculative-grade debt.

“Companies typically pledge all tangible and intangible assets against loans,” Chris Mawn, Portfolio Manager of Highland Capital Management’s senior loan ETF (SNLN), told ETF Trends. “As a result, loans have historically achieved default recoveries twice those of high-yield bonds. High-yield bonds also experience greater dispersion than loans in default recoveries.”

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Junk bonds have, however, performed well over recent months, which is largely attributable to interest-rate movements that resulted in relative underperformance of senior floating-rate loans. Year-to-date, the BofA Merrill Lynch US High Yield Index rose 11.8% while the S&P/LSTA U.S. Leveraged Loan 100 Index gained 7.1%. Consequently, Mawn argued that high-yield bonds may be overbought relative to senior loans and therefore more susceptible to a pullback.

“The relative value in senior secured loans compared to high yield is attractive to us right now,” Mawn said.

Moreover, senior secured floating-rate loans have, as their name suggests, a floating interest rate component, which fluctuates with market rates. Because rates are typically reset once per quarter, senior loans typically have 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, bank loans are seen as an attractive substitute to traditional corporate bonds in a rising rate environment.