3 Senior Loan ETFs To Play Rising Rates?

ratesInterest rates have been inching up ever since the Federal Reserve officials began the ‘taper’ talk, even though there is a lot of disagreement among the market participants about the likely time of start of ‘tapering’. The benchmark 10-year interest rate yield is now ~2.90%, a sharp increase from a low of 1.61% reached earlier this year.

Although many investors tend to shy away from bond ETFs in the current rising rate environment, there are still a number of appropriate choices in the fixed income ETF world. These products can help investors reduce their dependence on equities, while providing a nice regular payment above most stocks. At the same time, unlike most other fixed income instruments, these products do not lose value when the rates increase.

In the junk bond space, there is an often overlooked slice of the market that could be an interesting choice for those with minimal levels of exposure to the market. This corner has been the senior loans market, which provides investors some shelter from higher interest rates with above-average yields. (Read: Junk Bond ETF Investing: Is It Too Late?).

What is a Senior Loan?

Senior loans, also known as leveraged loans, are private debt instruments issued by a bank and syndicated by a group of banks or institutional investors. These provide capital to companies that have below-investment grade credit ratings. In order to compensate this high risk, senior loans usually pay higher yields.

Since the securities are senior to other forms of debt or equity, senior bank loans offer protection to investors should there be a credit event, especially if the loans are secured by property, equipment or other company items. As a result, default risk is low in this type of bonds, although these loans are issued on higher risk companies.

Further, senior loans are floating rate instruments and provide protection from rising interest rates. This is because senior loans usually have rates set at a specific level above LIBOR and are reset every three months, which help in eliminating interest rate risk.

Thanks to this, senior loans could be a nice mix between high income and lower interest rate sensitivity making them ideal investments for many. Further, they have low correlations with most other asset classes and could add diversification benefits to the portfolio. Thus, senior loan ETFs have gained immense popularity in recent months. The space has already proven to be a solid choice for yield without taking on too much interest rate risk.

Investors seeking decent yield in the current interest rate environment and willing to take some additional credit risk could play with senior loan ETFs analyzed below.

PowerShares Senior Loan Portfolio Fund (BKLN)

The fund tracks the S&P/LSTA U.S. Leveraged Loan 100 Index which acts as a benchmark for the largest institutional leveraged loans based on market weightings, spreads and interest payments. The ETF holds 132 securities in the basket with the vast majority maturing between one and 10 years.

With the average days to reset being just over 37, interest rate risk is minimal. Though senior loans account for a hefty 89% of the assets, high yield securities also make up for the remaining portion in the basket (read:HYLD: Crushing the High Yield ETF Competition).

The ETF debuted in March 2011 and is relatively expensive when compared to other ETFs focused on the low end of the debt market. The current expense ratio is 66 bps a year, which is thrice the low cost junk bond ETFs. However, the product enjoys heavy liquidity with average daily volume of roughly 2 million shares, suggesting no additional cost for the fund.

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