Leveraged loans and the Invesco Senior Loan ETF (NYSEArca: BKLN) are garnering more attention as of late, for the simple reason that income is getting difficult to find.
Due to low yields on other bonds, a growing economy, and low default rates, junk bonds are also commanding plenty of attention. Traditional high-yield corporates and bank loans, including BKLN holdings, are often compared to each other.
The comparison is relevant because the bulk of the bank loan universe carries junk ratings. For example, 82% of BKLN’s 144 holdings are rated BB, B, or CCC, according to Invesco data. Still, investors should note bank loans aren’t carbon copies of standard junk bonds.
For example, this form of debt is usually secured by something, meaning bondholders are higher up on the corporate totem pole than their traditional junk bond counterparts. The other side of that coin is that leveraged loans usually carry lower yields because they’re viewed as less risky than unsecured debt. BKLN’s 30-day SEC yield of 2.81% is below that of standard high-yield corporate bond benchmarks.
Bank loans also default at lower rates than junk bonds and the recovery rate for the former is higher. That’s something else for investors to ponder.
“It’s not just the default rate that matters for bank loans or high-yield bonds, but how much the bond or loan-holders receive after default, known as the recovery rate,” notes Collin Martin of Charles Schwab. “Over time, loans tend to have significantly higher recovery rates—due to their collateralized nature—than high-yield bonds. In the 12 months ending June 2021, the average recovery rate for loans was $55, compared to just $41.1 for traditional bonds. The difference is even wider over the last five years, with the loan recovery rate coming in at $63.4, compared with just $41.6 for bonds.”
Looked at differently, bank loans and BKLN are more defensive than standard junk bond strategies. Plus, senior loans offer the advantage of being more positively correlated to rising interest rates due to their floating rate component, though it might take awhile for that to benefit to materialize.
“Bank loans’ floating coupon rates help limit their interest rate sensitivity as well, but keep in mind that the coupons float off short-term yields, not long-term yields. It’s unlikely that bank loan coupon rates will rise until the Federal Reserve starts hiking short-term rates,” adds Martin.
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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.
