Bank loan

Reduce risk with bank loan ETFs

As Treasury yields fall rapidly from recent highs and yield spreads remain at historically low levels, bank loan ETFs could be an attractive option for income-sensitive investors wary of rising rates. .

Bank ETF loans can offer advisers and investors a safer option for the upside down path that high yield ETFs have experienced. And in terms of performance, they’re currently beating those riskier options.

Typically, high yield or “junk” bonds offer investors a larger spread than treasury bills in order to encourage them to take on the higher risk associated with these securities. Spread, or additional compensation in the form of higher returns, evolves in various market environments.

Collapsing yield spreads

In times of economic uncertainty, such as February and March 2020, high yield spreads widen as investors demand a higher payment to offset the increased risk of default associated with high yield bonds.

However, the economic optimism that characterized the equity and fixed income markets for most of the past year has reduced spreads to historically low levels.

The spread has the same negative correlation with bond prices as yields, meaning that bond prices rise when yields fall, and vice versa. Tight spreads mean high yield bonds could experience a price drop if economic uncertainty returns to fixed income markets.

In addition to the potential for widening spreads, traditional high yield bonds face the threat of rising interest rates, which would weigh more heavily on yields. Investors looking for yield might instead consider bank loan ETFs.

Benefits of bank loans

Bank loans have several advantages over high yield or higher quality bonds in today’s environment. For income-seeking investors, bank loan ETFs offer a similar return to high-yield ETFs.

The Invesco Senior Loan ETF (BKLN) offers a 30-day SEC yield of 2.9%, while the SPDR Blackstone Senior Loan ETF (SRLN) gives 3.9%. This is in line with the 3.4% return offered by the iShares iBoxx USD High Yield Corporate Bond ETF (HYG).

Chart courtesy of StockCharts.com

Unlike traditional high yield ETFs, however, the variable rate feature of bank loans means that the interest rate risk is considerably lower due to their shorter duration. In fact, the variable rate function means that this asset class can benefit from rising Treasury yields. The coupon is unrelated to the yield environment at issue, which makes this feature a significant advantage in a low interest rate environment.

Like high yield bonds, bank loans are still subject to credit risk and would be negatively impacted by widening spreads. As the variable rate reverts to a higher level in an environment of rising rates, it also increases the risk of default, as bond issuers have to pay more to service their debt.

However, bank loans are higher in capital structure compared to bonds. They have seniority in bankruptcy, which means they are the first creditors to be paid, which offers some protection in comparison.

Active or passive?

BKLN and SRLN both have over $ 6 billion in assets under management, but the similarities end there.

BKLN tracks a market value weighted index of senior loans issued by banks to businesses and is limited to the United States. The fund has an expense ratio of 0.65%.

SRLN takes an active approach to space, which includes the freedom to look into the international fixed income markets. For this active approach, SRLN commands a slightly higher expense ratio of 0.70%.

The active approach has benefited SRLN so far this year, allowing it to outperform HYG by 0.1%.

Although HYG has outperformed passive BKLN this year, investors should remember that squeezing spreads and falling interest rates have been responsible for much of this positive return. There isn’t much room for further downward movement on either bar.

When it comes to credit quality, SRLN also has a lower grade slant compared to BKLN.

Evaluation

BKLN

SRLN

BBB

14%

0%

BB

23%

5%

B

55%

79%

CCC

4%

14%

Unclassified

3%

2%

This contributes to its higher yield, as mentioned above, but could hurt the performance of the ETF in times of market stress.

An example of how this could play out was experienced from February to April last year. BKLN fell 10.8%, while SRLN fell 15.7%. HYG fell 13.6% over the same period.

Chart courtesy of StockCharts.com

Although the active management of SRLN has borne fruit so far this year, investors should be aware of the increased credit risk associated with the current allocation of the fund.

With the US economy’s path clouded by the COVID delta variant, a better-quality fund like BKLN might be a safer bet for those who want a more conservative option in this space.

Contact Jessica Ferringer at [email protected] or follow her on Twitter

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