By Dan Weiskopf, ETF Professor
Looking for Income? Are Senior Loans Right for You?
The current market value of Senior Loan ETFs is $19.8 billion across 7 funds, which is small compared to the $1.5 trillion invested in the overall market for these bonds. The yields on the Senior Loan category are between 3% and 4% with a surprising mix of differences in credit quality and maturities. These choices and differences are determined based upon active and passive fund strategies. This is important because when things go wrong and credit spreads widen, investors in the category will need to have long term confidence in the category. Here are some key elements to consider:
- Benefits: The income in the category should benefit from rising rates.
- Risk: Credit spreads may lead to meaningful short-term declines in price and an opportunity.
- Senior Loans are fixed income and high on the capital structure.
- ETFs that are actively managed can adjust to changing conditions, while passive funds will sell only on a prorated basis.
Breaking Down the Structural Problem: Interest Rates Will Be Trending Higher
Thesis: Interest rates on Senior Loans will adjust higher with rates.
Background: The historic long-term track records for ETFs have had similar outcomes, as shown in the Bloomberg chart below. According to ETF Action, these ETFs also have had a high correlation (.68 to .82) with the S&P 500 over the recent 3-year period, but also produced a lower return with a lower Beta (.25 to .35). Interested investors in the category need to consider three questions:
- Have inflation conditions and rising interest rates changed the value proposition for how bonds fit in a portfolio?
- Will higher rates create headwinds or tailwinds for equities that make the lower single-digits more compelling?
- Is the category set up for credit spreads widening?
An allocation to the Senior Loan category will depend upon an investor’s answer to these questions. It is evident that the category has held up lately relative to the Agg Index. However, due to the structural benefits of interest rate adjustments, questions about loosening of debt covenants in the next downturn will require active portfolio supervision. This decision can be handled by the fund being active as well as the financial advisor or investor reviewing what is owned in the portfolio.
In reviewing the history of the category, the next question investors need to ask is about the makeup of the portfolio as determined by active vs passive decision-making process. Using Bloomberg, the following chart was created to summarize the overlaps in credit ratings. In this chart, it is evident that the current variability between active and passive is the allocation between B and CCC rated bonds. Note that the credit structure has changed meaningfully since the 2014 interview with the former portfolio manager of SRLN, Lee Shaiman.
Credit Risk Spreads and Concern
As shown below, the widening of credit spreads historically follows major events, but currently remains tight despite worsening conditions between Ukraine and Russia.
The devastating loss of life that is taking place as a result of the Russia-Ukraine war will be highlighted and uncensored on social media. For markets, a secondary outcome sentiment will be reflected in the price action. As we move into this period of uncertainty, the robustness of financial advisors’ research process has never been more important. Let’s face it – in easy markets, little research is required as the structure of the portfolio masks mistakes and outcomes are most often pleasant. We encourage financial advisors and investors to review this information and the questions presented with a constructive eye. Circumstances and conditions may be aligning for future outperformance in the Senior Loan category versus the traditional fixed income and or even equity markets. Thinking long-term, the outlook for global inflation, interest rates and global commerce will be under review as long as the war continues. The decision to do nothing is still a decision with an outcome. Moreover, given that this asset class highlights so many different factors, we figured it would make sense to follow up on it in our Structure Matters series.
Footnotes and Interesting Tidbits
Outlook by Blackstone: https://www.ssga.com/us/en/institutional/etfs/insights/spdr-srln-commentary
Outlook by Invesco: https://www.invesco.com/content/dam/invesco/emea/en/pdf/2022_US_Senior_Loans_outlook.pdf
Primer and Explanation: https://www.spglobal.com/marketintelligence/en/pages/toc-primer/lcd-primer#sec1
Fitch Overview: https://www.fitchratings.com/research/corporate-finance/strong-4q21-m-a-volume-drives-inst-loan-market-record-2021-hy-issuance-despite-slow-4q-28-01-2022
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