Sizing Up Senior Loan ETFs

With bond markets pricing in an interest rate hike from the Federal Reserve next month, there could be some near-term headwinds for higher-yielding corners of the fixed income space, including senior loans.

Senior Loans

Floating rate notes and senior loans are unique in that their yield is tied to a benchmark such as LIBOR, rather than being fixed. Loans are also higher on the capital structure than other unsecured obligations, and some even carry floors to insure you earn a respectable yield even if rates stay low. Their coupon rate typically resets every 90 days, resulting in a duration shorter than three months, Benzinga previously reported.

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Senior Loan ETFs

Senior loan exchange-traded funds, such as the SPDR Blackstone/GSO Senior Loan ETF (SSGA Actice ETF Trust SRLN) and the PowerShares Senior Loan Portfolio (PowerShares Exchange-Traded Fund Trust II BKLN), feature tempting yields because these funds must entice investors for the elevated risk relative to, say, U.S. government or municipal bond ETFs. For example, BKLN, the largest senior loan ETF, has a 30-day SEC yield of 6.15 percent.

Due to their rate reset feature, BKLN, SRLN and rival funds tracking this asset class should not necessarily be babies thrown out with the rate hike bathwater. Credit quality, at least in theory, should be the concern, but on that senior loans and the relevant ETFs have advantages.

“Senior loans sound like a good deal. 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,” according to Morningstar.

Concern: Liquidity

Arguably the most prominent concern with senior loans is liquidity, a familiar refrain from critics of high-yield corporate bond ETFs. A common theory is that junk bonds are not the largest slice of the overall bond market, so in times of elevated market stress, there can be some liquidity crimping, though ETFs have proven to be nimble at adapting to trying market environments.

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The logic applied from there would be that senior loans are a smaller part of the high-yield space so if everyone heads for the exits at one time, there could be problems.

“Senior loan originators can sell their portion of the loan to other investors on the secondary market. Unlike traditional bonds, these loans do not settle on a T+3 schedule (three days after the transaction date). In fact, there is no maximum settlement period for these loans, though the median settlement period in the first three quarters of 2015 was 12 days according to the LSTA. That can pose a challenge to funds that provide daily liquidity such as mutual funds and exchange-traded funds,” added Morningstar.