Even with interest rates rising, investors can utilize floating-rate, high-yield, senior loan exchange traded funds to hedge against a rising interest rate environment.
Due to their floating rate component, bank 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.
Investors, though, should not forget that senior bank loans are denoted high-yield because the issuing firms are highly leveraged, and highly leveraged companies are more at risk of default and bankruptcy. Nevertheless, these bank loans are slightly safer than traditional high-yield bonds since they are secured by collateral and have historically shown lower default rates. However, there are risks to consider with exchange traded funds tracking senior loans, such as the PowerShares Senior Loan Portfolio (NYSEArca: BKLN). Risks include elevated credit risk, according to some analysts.
“his elevated credit risk is partially offset by the issuers’ improved cash flow positions for debt service compared with 10 years ago. The average interest coverage ratio increased from 3.25 times to 4.75 times from 2007 to 2017, according to S&P. However, it is important to note that leveraged loan coupons float with interest-rate movements. If rates continue to rise, the interest coverage ratio is likely to decline,” notes Morningstar.
Other Interest Rate Issues To Consider
Instead, bond investors may consider substituting credit risk for interest-rate risk to earn higher returns. For example, senior loans, bank loans or leveraged loans may act as an attractive alternative. A Senior loan is a private loan a firm takes from a bank or a syndicate of lenders. The loans are backed by the borrowers’ assets, which act as collateral. If the borrower defaults, lenders have a senior claim on the defaulters’ assets.
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