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What To Expect From Leveraged Loan ETFs As Rates Rise

ETF Professor

Leveraged loans, also known as senior loans, are embraced by bond investors as interest rates rise due in large part to the floating component sported by these bonds, which helps mitigate sensitivity to higher interest rates.

Exchange traded funds, such as the Invesco Senior Loan ETF (NYSE: BKLN), make leveraged loans more accessible to a broader swath of investors.

What Happened

BKLN tracks the S&P/LSTA U.S. Leveraged Loan 100 Index and is the largest ETF dedicated to leveraged loans. Year-to-date, BKLN has traded modestly lower, incurring losses that are significantly lower than those of more traditional, longer-dated bond ETFs.

Rates on leveraged loans float, but traditional junk bonds have fixed interest rates that remain constant until the bond matures. Senior loans are also considered attractive because they offer high yields, are collateral secured and, historically, have lower default rates than traditional high-yield corporate bonds.

“With expectations of higher rates ahead, leveraged loans remain highly attractive for market participants, due to their feature of coupon reset at a spread over a floating index (mostly the three-month LIBOR rate),” said S&P Dow Jones Indices in a recent note.

Why It's Important

Leveraged loans and ETFs such as BKLN aren't designed to be significant drivers of capital appreciation, but there have been periods when the asset class impressed on that front.

Since the S&P/LSTA U.S. Leveraged Loan 100 Index's January 2002 inception, “except during the global financial crisis of 2008-2009, the price return of the index has been stable and flat. In an orderly market, loans don’t provide much price appreciation due to the combination of floating LIBOR rate, lack of call protection, and possible refinancing at lower spreads,” said S&P Dow Jones Indices.

During that period, BKLN's index more than doubled. The ETF is seven and a half years old and is up nearly 3.3 percent since inception, as of Sept. 30.

BKLN has a 30-day SEC yield of 4.32 percent, which is below the yields of standard junk bond ETFs, but well above what investors get with investment-grade corporates or Treasuries.

“Though the spreads for loans have decreased since 2016, rising LIBOR rates have more than offset the spread narrowing and have pushed index yield to increase since 2017. The lower loan spreads also partially reflect the improving credit quality of the loan index,” according to S&P Dow Jones.

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