Due in part to the coupon reset feature, leveraged loans and exchange traded funds, such as the Invesco Senior Loan ETF (NYSEArca: BKLN), are often embraced by fixed income investors when interest rates move higher.
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.
“With expectations of higher rates ahead, leveraged loans remain highly attractive for market participants, due to their feature of coupon reset at a spread over a floating index (mostly the three-month LIBOR rate),” said S&P Dow Jones Indices. “In addition, leveraged loans generally provide higher protection than traditional high-yield bonds, since the loans are secured with collateral.”
Performance Expectations
Historical data indicate that leveraged loans do not always deliver significant price appreciation, but total returns can be solid over longer time frames. The inception of BKLN’s underlying index was in 2002.
“Except during the global financial crisis of 2008-2009, the price return of the index has been stable and flat. In an orderly market, loans don’t provide much price appreciation due to the combination of floating LIBOR rate, lack of call protection, and possible refinancing at lower spreads,” according to S&P Dow Jones. “However, the index delivered a cumulative 113% on a total return basis over the same period. The figure demonstrates that carry is the dominating source of return historically for leveraged loans over mid- to long-term investment horizons.”
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.
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