Investors Turn to Senior Bank Loan ETFs Ahead of Potential Rate Hikes

With more expecting the Federal Reserve to begin another round of interest rate hikes as soon as December, fixed-income investors are shifting into senior secured floating-rate bank loans and related exchange traded funds to hedge against rising rate risks.

The PowerShares Senior Loan Portfolio (NYSEArca: BKLN), the largest senior loan-related ETF on the market, has added $224.5 million in net inflows over the past week and attracted close to $1.5 billion in inflows over the past 90 days, according to Invesco PowerShares data.

The increasing influx in assets into the senior loan portfolio suggests that more investors are growing wary of a potential Fed rate hike and want to position their fixed income portfolios accordingly.

Looking at the Fed-funds futures market, options traders were pricing in a 70% chance of a rate hike in December, compared to a 50% chance a month ago, according to the CME Group. Investors added to bets that the Fed will hike interest rates on strong economic data and upbeat commentary from policy makers.

A rising interest rate would negatively affect bond funds as newer debt securities would come with a higher rate, making older bonds with lower yields less attractive. Consequently, bond investors may turn to senior loans as a way to mitigate the rate risks but still be able to generate attractive yields.

A senior loan is a private loan taken from an underwriting bank or a syndicate of lenders. The loans are 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. Moreover, senior secured floating-rate loans have, as their name suggests, a floating interest rate component, which fluctuates with market rates.

Since rates are typically reset once per quarter, senior loans typically have low durations – a measure of a bond fund’s sensitivity to changes in interest rates. The floating-rate component 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 debt in a rising rate environment.