Falling Interest Rates May Stall Bank Loan ETFs

As the Federal Reserve inches closer to a potential interest rate cut, ETFs investing in high-yielding bank loans have emerged as darlings of investor and financial advisors.

But that shiny object, in the form of yields that can hover around 9%, might be preventing investors from recognizing some cracks in the foundation of the strategy.

“The appeal is the yield, it’s fat,” said Paul Schatz, president of Heritage Capital in Woodbridge, Conn.

“These funds do well in a rising rate environment or a higher rate environment like we have been in, and they begin to look unattractive when rates curl under and start to go lower,” he added. “More importantly, they will struggle when the economy weakens and transitions into recession.”

JoAnne Bianco, investment strategist at BondBloxx in Larkspur, Calif., said the driving force behind the appeal of ETFs that own various below-investment grade syndicated bank loans comes down to one thing.

“Investors are looking at the yield associated with this asset class, and the defaults have been very low as the U.S. economy has remained resilient,” she said.

However, she added, the quality of the underlying assets has been trending toward lower quality.

“At least 60% of these loans are rated B-minus or lower, while only 30% of the high-yield bond market is rated B-minus or lower,” she said. “And there has been more downgrades in the bank loan market than in the high yield bond market.”

Bank Loan ETFs Gaining Appeal

Over the past few months, flows to bank loan ETFs have surged. 

The $8.3 billion Invesco Senior Loan ETF (BKLN) has received nearly $930 million over the past three months.

The $6.3 billion SPDR Blackstone Senior Loan ETF (SRLN) has generated more than $590 million in inflows, while the $505 million Franklin Senior Loan ETF (FLBL) took in $171 million over the same period.

David Kline, private wealth advisor at Integrated Partners in Waltham, Mass., is concerned about the risk of jumping into the category at this point in the market cycle.

“A lot of investors may have missed the boat the last few years with leveraged loans since they were concerned about credit risk,” he said. “However, a challenge with jumping in now is that leveraged loans have zero duration, and if rates move lower there would actually be a negative impact, and investors would not be totally compensated.”

Matt Malone, head of investment management at the private markets platform Opto Investments in New York, is also advising caution.

“Although defaults remain low, this doesn't tell the whole story as lenders, particularly in private credit, have the ability to waive defaults and restructure to avoid headlines,” he said. “Instead, investors should look at the continuing rise in non-cash interest payments in this space as an indicator of quality and potential for distress and lower returns.”