Reconsidering Senior Loan ETFs

Leading up to the Federal Reserve's December meeting, presumably when the Fed's first interest rate hike in nine years will take place, plenty of corners of the fixed income market have been punished. That includes bank loans or senior loans, a high-yielding fixed income asset class back when the notion of the Fed raising rates was laughable.

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 reported earlier this year.

A common ding against junk bond exchange traded funds is the potential for a negative liquidity event, a concern that has made its way to the arguably thinner world of senior loans. With that in mind, this an asset class where active management might have some perks. Enter the SPDR Blackstone / GSO Senior Loan ETF SRLN. Home to $783.3 million in assets under management, SRLN is one of the largest actively managed ETFs on the market today.

Although interest rates are poised to rise and rise soon, investors should keep in mind that senior loan ETFs do not sport the rate risk some investors perceive these funds to have.

“Senior loans are floating rate instruments whose interest rates are benchmarked to LIBOR plus a spread to compensate for credit risk. Senior loans reset every three months. It’s important to note that most loans do contain a floor and the loan’s coupon resets only when LIBOR exceeds that floor, which on average is around 100 basis points,” said State Street Global Advisors Vice President David Mazza in a recent note. 

In terms of credit quality and risk, neither is a major concern with SRLN because the ETF is lightly allocated to troublesome CCC-rated debt. Junk bonds rated CCC and lower have been the high-yield market's worst performers this year. SRLN allocates barely more than three percent of its combined weight to bank loans rated CCC+ and CCC. Over three-quarters of SRLN's lineup is rated B, B+, BB- and BB.

As Mazza notes, senior loans have had a vastly superior recovery rate over the past two decades than traditional junk bonds. 

“Senior loans are senior to most high-yield bonds in the corporate credit structure. In the event of default, senior loans have a higher recovery rate than high yield bonds. This means senior loans have the potential to be less risky than bonds issued from the same company,” he said.