As market participants anticipate multiple interest rate hikes by the Federal Reserve this year, fixed-income investors are shifting into senior secured floating-rate bank loans and related exchange traded funds to hedge against rising rate risks.
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. The PowerShares Senior Loan Portfolio (NYSEArca: BKLN) is the largest ETF offering exposure to the asset class.
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.
“Bank loans are another good option now. They are generally made to below-investment-grade companies, so there is plenty of credit risk. But their rates float, which means they adjust—as interest rates rise, so will those on these loans,” reports Reshma Kapadia for Barron’s.
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.
A possible risk with bank loans is that these bonds are not as liquid as U.S. government debt or investment-grade corporate bonds.
“Credit risk worked well for investors last year, and could again if corporate earnings rise and the economy strengthens. The $8.3 billion PowerShares Senior Loan ETF (BKLN) is the biggest and one of the cheapest options, with an expense ratio of 0.65% and a yield of 4.54%,” according to Barron’s.
For more information on the fixed-income market, visit our bond ETFs category.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.