Senior Loan ETFs are becoming increasingly popular with investors as they provide high yields with protection against interest rate risk.
Recent ETF fund flows show that investors are getting increasingly worried about the interest rate risk in their bond portfolios. While more interest rate sensitive ETFs lost assets under management, funds with less interest rate sensitivity/shorter duration gathered assets.
The statement released after the recent Fed meeting indicated that they are prepared to increase or reduce the pace of asset purchases as the outlook for the labor market or inflation changes. (Read: Why I hate Volatility ETFs and why you should too)
However minutes from the last couple of FOMC meetings revealed that there is a growing debate within the committee about continuation of asset purchases at current levels. Once the Fed slows down its purchases, interest rates will start to rise. In fact, the ten-year note did break the psychological barrier of 2% earlier this year but the yield declined later on account of renewed concerns about economic growth. Within the fixed income space, junk bonds appear to be at highest risk, in the event of an interest rate rise.
Investors looking for higher yields, but concerned about the potential rise in interest rates should look at Senior Loan ETFs. (Read: 3 Excellent REIT ETFs you should not ignore)
What are Senior Loans?
Senior loans are secured by company’s assets and are thus lower in risk structure, even though these loans are mostly issued by companies with below investment grade credit. These are floating rate loans so they usually pay a spread over some benchmark rate like LIBOR. Thus, in the event of rise in interest rates, coupons on senior loans increase while the value of the investment remains stable. (Read: Buy these ETFs to profit from Japan’s massive easing)
On the other hand, bonds lose value if the interest rates go up. So, investors in senior loans or in senior loans ETFs get the benefit of high yields with protection against any interest rate rise. Further, they carry lower credit risk compared with most other assets with similar level of yield. Additionally senior loans have low correlations with other asset classes
FTSL in Focus
The First Trust Senior Loan Fund (FTSL) that began trading yesterday is First Trust’s fourth actively managed ETF.
According to First Trust press release-- the Fund attempts to outperform the S&P/LSTA U.S. Leveraged Loan 100 Index and the Markit iBoxx USD Leveraged Loan Index. It seeks to generate high current income and preserve capital by investing primarily in a diversified portfolio of first-lien senior floating rate bank loans.
Can it succeed?
FTSL is the fourth product in the Senior Loan ETFs space and second actively managed product.
Per First Trust, “While an index-based senior loan ETF principally considers the market value of the debt issuance outstanding in its selection methodology, an actively managed ETF gives us the latitude to utilize our rigorous credit process in evaluating an individual company’s ability to repay its debt, which we believe is paramount to driving attractive risk-adjusted and absolute returns over the long term”.
The first product in this space PowerShares Senior Loan Portfolio (BKLN), which was launched in March 2011 has been quite popular with investors, attracting about $3.8 billion in assets so far.
Other two products are relatively new-- Pyxis/iBoxx Senior Loan ETF ( (SNLN) launched in November last year and SPDR Blackstone / GSO Senior Loan ETF (SRLN) launched last month. It remains to be seen whether actively managed products will become more successful in this specialized space.
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