Though interest rates have inched up, they’re still pretty low, leaving fixed-income investors scrambling to find better yields. But higher yield usually means taking more risk, and many investors are leery of options like high-yield or foreign bonds.
But there’s another often overlooked alternative: senior loans, also called bank loans and leveraged loans, from banks to companies with less-than-perfect credit. Investors can get into them easily through exchange-traded funds.
Senior loans are riskier than bank savings or U.S. Treasurys but a tad more generous. The PowerShares Senior Loan ETF (ticker: BKLN) tracks an index of large loans and yields 4.54 percent with expenses of 0.65 percent, or $65 per $10,000 invested. That yield is rich next to more traditional investments like Vanguard Total Bond Market Index Fund ETF Shares ( BND), yielding 2.47 percent with expenses of 0.04 percent.
Coleen Pantalone, associate finance professor at D’Amore-McKim School of Business at Northeastern University in Boston, says senior loan ETFs offer investors attractive yields, another degree of diversification and protection against loss of principal when interest rates rise, as many expect in the next year or so.
[See: The 10 Best Dividend Stocks of 2016.]
“These are usually floating-rate loans, so when interest rates rise, as we expect them to, the return these loans generate will also rise,” she says.
Senior loans are loans from financial institutions like banks to non-investment-grade companies with credit that’s less than stellar but better than the typical junk bond issuer. Borrowers put up assets as collateral, and the lender gets paid back ahead of other lenders and creditors — the reason for the term “senior.” Borrowers pay higher interest than they might for other types of loans, but not as much as if they sold junk bonds.
Senior loan ETFs invest in these loans.
“The senior loan ETF space is small, with just a handful of ETFs providing exposure to senior bank loans,” says Jeff Bishop, co-owner of Raging Bull, an investment education company in Arlington, Texas.
BKLN is one of the largest of these ETFs, along with SPDR Blackstone/GSO Senior Loan ETF ( SRLN), yielding 3.94 percent (expenses: 0.70 percent). Because it’s a small niche, senior loan ETFs are unfamiliar to many investors.
“Those who do not have a high risk tolerance or do not fully understand the intricacies of senior loans should stay away from bank loan ETFs,” Bishop says.
“Senior loans sound like a good deal,” Alex Bryan, Morningstar’s director of passive strategies research, says in an investor newsletter last year. “They have historically had lower credit losses than high-yield bonds, less interest-rate risk than intermediate-term fixed-rate bonds, and higher yields than many other short-duration instruments. But it is important to bear in mind that these high yields are compensation for risk. In addition to their credit risk, these loans carry considerable liquidity risk.”
Liquidity risk is the chance that the lender won’t be able to sell the borrower’s assets quickly in a default, or that a fund owning loans won’t be able to sell them fast enough to generate cash for investor redemptions.
“Senior loans are generally less heavily traded than bonds,” Bryan says. “If a manager wants to sell a loan, it may take longer to find a buyer and he may have to accept a lower price to make the transaction happen.”
[See: 10 ETFs That Pay Sky-High Dividends.]
This translates into risk for the fund’s investors, though Bryan says funds use several effective techniques to handle this problem, such as keeping cash on hand, investing in only the most liquid loans and setting up a line of credit.
“Senior loans are really bank loans and the resale market is not as liquid as, say, the stock market,” Pantalone says. “The fund will not be able to liquidate these loans overnight. So, if lots of people are trying to sell their ETFs at the same time, it may be difficult to get your money out quickly and without taking a huge loss.”
Because illiquid assets are hazardous, Bryan recommends actively managed products like SRLN. It focuses on large loans that are more liquid than small ones.
Bonds and bond funds typically face interest-rate risk, when rising rates on new securities undermine prices on older ones with lower yields. But this risk is not severe with senior loans because they carry floating rates.
Typically, senior loans reset interest rates charged to borrowers every quarter by adding a margin to the London Inter-Bank Offered Rate, or Libor, which floats with market conditions.
“Right now, Libor is very low,” Pantalone says. “How much will it have to rise before the return on this investment goes up?”
She also urges investors to study fees, which can be higher on senior loan ETFs than on ETFs following more liquid assets like stocks and ordinary bonds.
“Finally, examine the loan portfolio — is it diversified and what is the target duration?” she says.
Duration, expressed in years, tells how much the ETF’s price will change with every one-percentage point change in prevailing rates.
“Loans with a shorter duration will be repaid sooner, so they are less risky,” Pantalone says.
[Read: Why the Bond Market Pullback Shouldn’t Worry Investors.]
“Senior loan ETFs could serve as a hedge against rising interest rates, but there are some tradeoffs, such as taking on some default and credit risk,” Bishop says. “However, most bank loan ETFs compensate these risks by providing higher yields. Keep in mind that senior loan ETFs are best suited for individuals who understand the intricacies.”
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How to Invest in Senior Loans originally appeared on usnews.com
