Bank Loan ETF Or High Yield ETF?

If you had to choose between a bank loan ETF or a high-yield bond ETF as a source of yield, which would you pick? Each category has its benefits, but when it comes to risks associated with hunting for yield, it seems high-yield bonds have an upper hand at the moment.

Consider these two funds as examples of each category: the PowerShares Senior Loan ETF (BKLN | C) and the iShares iBoxx $ High Yield Corporate Bond ETF (HYG | B-64).

Year-to-date, the funds’ performances haven’t been that dramatically different:

Chart courtesy of StockCharts.com

Liquidity Core Issue

The core issue is liquidity, Will McGough, portfolio manager and senior vice president at Stadion Money Management, says.

“We don’t have a strategy that chooses high yield or bank loans—either or—but if we did have to choose, given the current macro backdrop, we would favor the liquidity of high yield over the illiquidity or unknowns of bank loans,” McGough told ETF.com.

“Bank loans are not technically ‘securities’ the way other capital assets are, have nonstandardized settlements, and are much more of an over-the-counter-type trading structure, which means they’re more manual and tedious to trade, and that affects price discovery,” he said.

‘Undue Stress’

Yes, ETFs have a done a great job at trading tighter than the underlying markets for bank loans, “but if a period of stress comes along, with the advent of bank loan ETFs, we might see extra undue stress, as they are a more opaque market relative to high yields,” McGough said.

Investors tend to like bank loans anyway because they are higher in the corporate structure, and because they are floating-rate securities. That means their coupons adjust with changes in interest rates—something that offers income without much duration risk at a time when everyone is concerned about duration exposure in a rising-rate environment.

In fact, PowerShares estimates that “when considered per unit of duration, senior loans have averaged more than 10 times the yield of high-yield bonds over the past decade.”

Attractive Yields

The PowerShares Senior Loan ETF (BKLN | C) tracks an index comprising the 100 largest bank loan facilities—floating-rate, high-yield senior debt issued by banks to companies. As of Oct. 7, BKLN was dishing out 30-day yield of 5.56 percent in a portfolio with weighted average maturity of 4.6 years.

That yield profile explains the resonance of the strategy with investors—the fund today has $4.7 billion in assets.

But the rewards come with risks—doesn’t it always?

“While the floating-rate feature greatly reduces sensitivity to changes in interest rates, the fund takes on heightened credit risk, with most issues rated below investment grade,” according to ETF.com Analytics. “Also note that a spike in interest rates will make it harder for issuers to service their debt.”

Best Carry Available

And there’s also the issue of carry [the spread between the yield on bank loans and that of high-yield bonds], Anthony Parish, vice president of research at Sage Advisory, points out.

“People like bank loans, but high yield wins because of the carry,” Parish said. “That carry is more than enough to compensate for the difference to bank loans.”

The iShares iBoxx $ High Yield Corporate Bond ETF (HYG | B-64) has a slightly shorter average maturity than the broad segment due to lower exposure to bonds with 10-plus years to maturity, according to ETF.com data. But it offers “marketlike” credit risk.

The portfolio has weighted average maturity of 6.1 years—roughly 1 ½ years more than BKLN—and a 30-day yield of 6.81 percent. To put these numbers into perspective, a 10-year Treasury is yielding today 2.08 percent.

Beware Of Risks In Yield Hunt

Still, Parish is quick to point out that credit risk is real, and should be carefully considered.

“The risk of interest rates is overblown relative to credit risk,” Parish said.

According to him, we are seeing all-time record corporate issuance, a maturing credit cycle, record merger and acquisition activity—all traits of an environment where “duration is your friend, but we’ve been reducing exposure to corporates,” he said.

The carry may be attractive relative to bank loans, but taking on credit risk now in the form of high-yield exposure just isn’t that appealing altogether.

In one of Stadion’s strategies, for example, high-yield exposure is treated as if it were equity, meaning the firm runs an equity-oriented model to tactically decide when to have high-yield exposure or not, McGough says—like any other risky asset.

“Our research has shown that high-yield bonds typically trade more in lock step with equity markets than fixed-income markets,” he said. “Obviously, correlation and sector concerns can cause something like high yield to disperse from both traditional equity and fixed income.”

Contact Cinthia Murphy at [email protected].