Financial media and many bond investors typically focus on traditional high-yield corporate bonds when discussing riskier corporate debt, but some market observers argue more attention should be paid to leveraged loans, an asset class accessible via exchange traded funds such as the Invesco Senior Loan ETF (NYSEArca: BKLN).
Leveraged loans, also referred to as bank loans or senior loans, are seen as an attractive alternative to traditional high-yield corporate bonds in a rising rate environment. Bank loan securities allow their interest rate to shift, or float, along with the rest of the market, whereas a fixed interest rate stays constant until maturity.
BKLN targets the S&P/LSTA U.S. Leveraged Loan 100 Index. That index “is designed to track the market-weighted performance of the largest institutional leveraged loans based on market weightings, spreads and interest payments,” according to Invesco.
“The attention should be focused on the leveraged loan market which is now larger than the high yield bond market,” writes Peter Tchir for Forbes. “According to Bloomberg, the leveraged loan market is now bigger than the high yield bond market, but barely gets the attention it deserves. The Fed did notice this market last week in its statement, which I found encouraging as I’ve been highlighting the potential problems for several months.”
Inside Leveraged Loans
A leveraged or 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.
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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.
“The demand from CLO’s (Collateralized Loan Obligations) has been insatiable – creating so much demand, that price discovery has also been low,” according to Tchir. “Add to the fact that it is hard to know how ‘senior secured’ you are when there isn’t unsecured debt below you in the capital structure, the dominance of covenant lite loans and you have a recipe for low transparency and little price discovery.”
Tchir adds that leveraged loans could provide more accurate warnings regarding market stress than traditional junk bonds, should that scenario arrive.
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