Fixed-Income ETFs: Intro To Bank Loans

Fixed-Income ETFs: Intro To Bank Loans

Senior bank loans are a form of debt financing issued by a private institution.

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Senior bank loans are a form of debt financing issued by a private institution. The "senior" in their name refers to their place in the capital structure of a firm. Senior loans are typically the highest-priority credits on a firm's balance sheet, meaning, in the event of a bankruptcy or liquidation, they're repaid before any other type of financing. That means senior loan holders expect to be paid before bond and note holders as well as general creditors and equity shareholders.

As with any financial instrument, the yield provided by senior loans is directly related to their place in the capital structure of the firm and the risk they carry. Because senior loans are senior to all other debt instruments, the yield on these securities is typically lower than on the other forms of debt offered by a firm. Furthermore, most senior loans are collateralized by specific firm assets. Said another way, senior loans are secured against a lien on the assets of the company who issues them. These assets are not tied to any other debt instruments, meaning, in the event of a bankruptcy, these assets must be liquidated to repay the senior loans before any other creditor can be repaid from the proceeds of the sale. Again, this suppresses the yield of senior bank loans relative to other forms of corporate debt.

Senior loans are floating-rate instruments whose rates are typically benchmarked to Libor. They are reset on a regular basis—every 30, 60 or 90 days—with an agreed “spread” to the benchmark. For example, if Libor is 5 percent, a senior loan with a spread to Libor of 250 bps will have a yield of 7.5 percent. If the reset period is 30 days and Libor rises to 5.5 percent at the next reset, the yield will be 8 percent. It’s important to note that although senior loans may be considered a hedge against rising rates, they typically have a rate ceiling to prevent the rate from rising above a certain threshold.

Further, there are two types of senior loans: investment-grade and leveraged loans. Investment-grade senior loans are issued by firms with high credit ratings who have other funding options available to them. These are considered “safer” and therefore tend to have lower yields or spreads. Leveraged loans, on the other hand, are typically issued by firms with credit ratings below BBB-/Baa3 that tend to have significant liabilities. These loans are considered to be much riskier and therefore carry higher yields or spreads. Due to the elevated credit risk, they are also often issued by a syndicate of banks rather than one individual bank, so as to diversify the risk to creditors.

The senior bank loan market is a relatively small slice of the capital market pie, making the securities fairly illiquid compared with other forms of corporate debt. ETFs that track senior loans therefore pull from a fairly small and illiquid universe, meaning the ETFs that hold them are relatively less liquid than their corporate bond peers and will be disproportionately affected by credit events.

Investors considering senior loan ETFs should therefore pay close attention to the credit ratings of the issuing firms. Although their status as senior credits and the collateralized nature of the loans suppresses risk, investors in senior loans are not immune from credit risk. Further, because the rates on these loans are often capped, they’re not completely immune from interest-rate risk despite their floating-rate design.

Next: Fixed-Income ETFs: What Happens During Bond Panics? (Premiums, Discounts And More)

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