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.
The $7.82 billion BKLN holds 116 bonds and tracks the S&P/LSTA U.S. Leveraged Loan 100 Index. BKLN’s underlying 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.
“Senior loans’ yields go up in lock step with short-term interest rates, offering an effective duration hedge, but they come with significant credit risks, as most of these loans are issued by companies rated below investment grad,” said Morningstar.
Senior Loans & Low Durations
Because rates are typically reset once per quarter, senior loans typically have low durations. Since the senior loans have rates that adjust periodically, the floating-rate loans also offer investors an alternative method of earning yields while mitigating interest-rate risk.