High-Yield Bank Loan ETFs: Credit Risk vs. Rate Risk

ETF Trends

Bank loan ETFs have weathered the recent turbulence in interest rates relatively well as investors try to guess the Federal Reserve’s next move on quantitative easing.

While many have steered toward bank loans as a rate hedging tool, don’t forget that the assets are still speculative in nature.

Brian Frederick, a principal at Stillwater Financial Partners, among others, argues that bank loans can be even riskier than junk bonds, reports Constance Gustke for CNBC.

“These companies have a hard time even issuing junk bonds,” Frederick said in the article.

Bank loans funds are comprised of loans  to corporations made by banks and other financial institutions. These debt securities are typically rated speculative grade, or considered “junk.”

Allan Roth, founder of advisory firm Wealth Logic, believes that investors shouldn’t forgo more credit risk for less interest rate risk.

“Between credit risk and interest rate risk, boy, I would I rather take on rate risk,” Roth said in the article. “Interest rate risk, you lose the opportunity cost of yield; credit rate risk, you lose everything.”

“Perhaps the largest risk to bank loans is the potential for a U.S. recession in the near future,” Morningstar analyst Timothy Strauts explained. “While this is not expected by the majority of surveyed economists, current federal spending cuts will have a negative impact on GDP growth in the near term. A recession could increase defaults in the bank-loan sector, which would depress the prices of loans.”

Nevertheless, speculative-grade bonds still have low default rates. S&P projects default rates were 2.6% in June 2013 and could rise to 3.1% in June 2014. In August, the default rate for leveraged loans was 2.2%. The long-term average has been 4.5%.

Observers, though, warn that a flight to quality could cause a sell-off in bank loans, but there has not been a big enough move in investment-grade debt to instigate an exodus from high-yield yet.

Many investors and advisors sought out bank loans as a way to mitigate the effects of rising interest rates while generating attractive yields. [Bank Loan ETFs Still in the Groove as Interest Rates Rise]

“Advisors really like loan funds for their floating rate nature—it greatly reduces their interest rate risk so investors aren’t burned in a rising rate environment. Still a credit risk, but with low rates elsewhere, they’re stuck with this for income,” Jeff Tjornehoj, head of Lipper Americas research, said in the article. [Bank Loan ETFs for Yield and Rising Rate Hedge]

Investors interested in senior floating rate bank loan ETFs can take a look at PowerShares Senior Loan Portfolio (BKLN) , Highland/iBoxx Senior Loan (SNLN) , SPDR Blackstone/GSO Senior Loan ETF (SRLN) or First Trust Senior Loan Fund (FTSL) .

For more information on fixed-income assets, visit our bond ETFs category.

Max Chen contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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