Reducing Risk With Bank Loan ETFs

With Treasury yields quickly falling from recent highs, and high yield spreads remaining at historically low levels, bank loan ETFs could be a compelling option for income-sensitive investors who are wary of rising rates.

Bank ETF loans can offer advisors and investors a safer option when it comes to the topsy-turvy path high yield ETFs have seen. And performancewise, they are currently beating those riskier options.

Generally, high yield or “junk” bonds offer investors a spread above Treasuries in order to give investors incentive to take on the higher risk associated with these securities. The spread, or extra compensation in the form of higher yields, shifts in various market environments.

Collapsing Yield Spreads

In times of economic uncertainty, such as February and March 2020, high yield spreads widen as investors demand a higher payment to compensate for the increased risk of default associated with high yield bonds.

However, the economic optimism that has characterized both equity and fixed income markets over much of the past year has brought spreads down to historically low levels.

The spread has the same negative correlation to bond prices as yields do, meaning bond prices move up when yields drop, and vice versa. Tight spreads mean high yield bonds could see a decline in price should economic uncertainty work its way back into the fixed income markets.

In addition to the potential for widening spreads, traditional high yield bonds face the threat of rising interest rates, which would further eat into returns. Investors who are searching for yield might want to consider bank loan ETFs instead.

Benefits Of Bank Loans

Bank loans have several advantages over high yield or investment-grade bonds in the current environment. For income-seeking investors, bank loan ETFs offer a similar yield to high yield ETFs.

The Invesco Senior Loan ETF (BKLN) offers a 30-day SEC yield of 2.9%, while the SPDR Blackstone Senior Loan ETF (SRLN) yields 3.9%. This is in line with the 3.4% yield offered by the iShares iBoxx USD High Yield Corporate Bond ETF (HYG).

Chart courtesy of StockCharts.com

Unlike traditional high yield ETFs, however, the floating rate feature of bank loans means that interest rate risk is significantly lower due to their lower duration. In fact, the floating-rate feature means that this asset class can be a beneficiary of rising Treasury yields. The coupon is not tied to the yield environment at issuance, making this feature a strong benefit in a low rate environment.

Similar to high yield bonds, bank loans are still subject to credit risk, and would be negatively impacted by widening spreads. As the floating-rate resets to a higher level in an increasing rate environment, this also increases default risk, as bond issuers must pay more to service their debt.

However, bank loans are higher in the capital structure relative to bonds. They have seniority in the event of bankruptcy, meaning they are the first creditors to be paid, which offers some level of protection in comparison.

Active Or Passive?

Both BKLN and SRLN have over $6 billion in assets under management, but the similarities end there.

BKLN tracks a market-value-weighted index of senior loans issued by banks to corporations, and is constrained to the U.S. The fund has an expense ratio of 0.65%.

SRLN takes an active approach to the space, which includes having the freedom to look in international fixed income markets. For this active approach, SRLN commands a slightly higher expense ratio of 0.70%.

The active approach has benefited SRLN so far this year, allowing it to outperform HYG by 0.1%.

While HYG has outperformed the passive BKLN this year, investors should remember spread compression and falling interest rates have driven much of this positive return. There is not much room for further downward movement on either measure.

When it comes to credit quality, SRLN also has a lower quality tilt relative to BKLN.

This contributes to its higher yield, as mentioned above, but could hurt the ETF’s performance in times of market stress.

An example of how this could play out was experienced last February through April. BKLN fell by 10.8%, while SRLN fell by 15.7%. HYG fell by 13.6% in the same time period.

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Chart courtesy of StockCharts.com

While the active management of SRLN has paid off so far this year, investors should be aware of the increased credit risk associated with the current allocation of the fund.

With the path of the U.S. economy is clouded by the COVID delta variant, a higher quality fund like BKLN might be a safer bet for those who want a more conservative option in this space.

Contact Jessica Ferringer at [email protected] or follow her on Twitter