With Treasury yields falling rapidly from recent highs and high yield spreads remaining at historically low levels, bank loan ETFs can be a compelling option for income-sensitive investors who are wary of rate hikes.
Bank ETF loans can offer advisors and investors a safer option when it comes to the steep path that high yield ETFs have seen. And from a performance standpoint, they currently bypass these riskier options.
Typically, high yield or junk bonds offer investors a spread over Treasury bonds to give investors an incentive to take on the higher risk associated with these securities. The spread, or additional compensation in the form of higher yields, varies in different market conditions.
Reducing yield spreads
In times of economic uncertainty such as February and March 2020, high yield spreads widen as investors demand higher payments to offset the increased risk of default associated with high yield bonds.
However, the economic optimism that has characterized both equity and fixed income markets for much of the past year has reduced spreads to historically low levels.
Spread has the same negative correlation with bond prices as yield, that is, bond prices rise when yield falls, and vice versa. Tight spreads mean high yield bond prices could fall if economic uncertainty returns to fixed income markets.
In addition to widening spreads, traditional high yield bonds face the threat of higher interest rates, which will further reduce yields. Investors looking for profitability may instead consider using bank loan ETFs.
Benefits of bank loans
Bank loans have a number of advantages over high yield bonds or investment grade bonds in the current environment. For investors looking to make money, bank loan ETFs offer the same returns as high yield ETFs.
IN ETF Invesco Senior Loan (BKLN) offers a 30-day SEC return of 2.9%, while SPDR Blackstone ETF Equity Loan (SRLN) gives 3.9%. This is in line with the 3.4% yield offered by iShares iBoxx USD ETF for High Yield Corporate Bonds (HYG)…
Chart courtesy of StockCharts.com
However, unlike traditional high yield ETFs, the property of floating rate bank loans means that the interest rate risk is significantly lower due to their shorter duration. In fact, the floating rate function means that this asset class can be the beneficiary of an increase in Treasury yields. The coupon is not tied to the yield on issue, making this a significant advantage in a low interest rate environment.
As with high yield bonds, bank loans remain subject to credit risk and will be negatively impacted by widening spreads. As the floating rate returns to a higher level in the face of higher rates, it also increases the risk of default as bond issuers have to pay more to service their debt.
However, bank loans in the capital structure are higher than bonds. They have seniority in the event of bankruptcy, which means that they are the first lenders to receive money, which offers some level of protection compared to them.
Active or Passive?
Both BKLN and SRLN manage over $ 6 billion in assets, but the similarities end there.
BKLN tracks a market value-weighted index of priority loans issued by banks to corporations and is capped for the United States. The fund’s expense ratio is 0.65%.
SRLN is taking an active approach to this space, which includes the freedom to search in international fixed income markets. For this proactive approach, SRLN offers a slightly higher expense ratio of 0.70%.
The proactive approach benefited SRLN this year, surpassing HYG by 0.1%.
While HYG has outperformed the passive BKLN this year, investors should be aware of the narrowing spreads and falling interest rates that have largely contributed to this positive yield. For both indicators, there is not much room for further downward movement.
In terms of credit quality, SRLN also has a lower quality level compared to BKLN.
This contributes to its higher returns, as mentioned above, but can negatively impact ETF performance during market stress.
An example of how this could have happened was in the past from February to April. BKLN fell 10.8% and SRLN fell 15.7%. HYG fell 13.6% over the same period.
Chart courtesy of StockCharts.com
While the active management of SRLN has paid off this year, investors should be aware of the increased credit risk associated with the current fund allocation.
As the US economy’s path has been clouded by the COVID delta option, a better-quality fund like BKLN may be a safer choice for those looking for a more conservative option in this space.