Senior Loan ETF Yielding 5.1% Is A Good Idea Even When Interest Rates Are Falling
What Are Senior Loans?
Fitch defines a senior loan as a commercial loan to a high-yield company provided by a group of lenders. Other names commonly used are bank loans, leveraged loans or syndicated loans. These loans are typically senior secured debt (secured by the borrowing company’s assets) and are at the top of a company’s capital structure – i.e. they have a first lien on assets in the event of a bankruptcy.
Exhibit 1: Senior loans in the capital structure
Leveraged bank loans are often floating rate and priced at a spread over a referenced rate. They are generally issued with maturities of seven to eight years but can be prepaid sooner without penalty.
There are different views as to why they are termed “leveraged”: one is because of the below investment grade credit quality, another is because they are oftentimes used to fund leveraged buyouts.
Because they are floating rate they have a very short duration. For readers needing a refresher on duration, it is basically the number of years it takes for an investor to be repaid the bond’s price by the expected estimated cash flows. It also measures the sensitivity of a bond’s price to changes in interest rates. Variables the reduce duration are higher coupons, shorter terms to maturity, and floating rates. In times of rising rates, you therefore would prefer to hold shorter duration bonds, while longer duration bonds are preferred when rates are falling.
Exhibit 2: High income and no duration
Senior loans have characteristics that differentiate them from other debt instruments in a company’s capital structure. Bank loans are floating-rate securities, and the coupons are reset quarterly at a set spread above three-month LIBOR. For companies that have unsecured bonds, bank loans are senior to unsecured obligations in the capital structure, meaning in the event of a default they receive principal ahead of bonds. Thanks to bank loans’ senior position in the capital structure, they also exhibit less volatility than unsecured debt in times of heightened volatility.
Senior loans are issued by lower credit quality or high yield issuers. These issuers have a more highly leveraged balance sheet relative to investment grade issuers in the same sector or industry. Like in high yield or junk bonds, a leveraged loan investor is taking on greater risk by lending to an already indebted firm.
It wasn’t until the late 1990s when bank loans attracted non-bank investors. Loans were syndicated by banks and were made available to institutional investors by means of standardization of documentation, which reduced the time and expense of bringing them to market. In addition, the structured vehicles market created a pool of leveraged loans to offer collateralized loan obligations (CLOs), a different type of product to offer investors. Today, two-thirds of the bank loan market are packaged in CLOs.
Fixed income diversifier
As opposed to fixed-rate debt, senior loan performance is rising in lockstep with the Federal Reserve’s tightening, which is counter to typical fixed income logic. This is because leveraged loans typically have floating rate structures which reduce or eliminate interest rate risk and reset on a regular basis. As a result, senior loans have a negative correlation with treasuries.
Exhibit 3: Correlation with Treasuries
Falling interest rates
As we said before, bank loan coupons adjust periodically based on changes in short-term interest rates. That means they don’t lose money the way fixed-rate bonds do during rising-rate environments.
But currently the Fed is lowering interest rates. Should we lose interest in bank loans now that rates have begun to fall? It’s a common gut reaction for those who have a narrow view of loans as a tactical play on interest rates.
The rationale is that fixed rate assets are better positioned for falling rates than floating rate loans. However, this thinking undervalues the critical long-term return drivers for senior loans:
the relatively high absolute coupon rates which are comprised of LIBOR plus credit spread, and loans’ advantageous position within the capital structure which mitigates the risk of credit loss.
These features have historically contributed to loans’ lower price volatility relative to other credit risk assets. Even as interest rates decline, loans’ overall coupons will remain strong. The income provided by loans tends to be relatively stable when rates decline (typically during periods of macroeconomic weakness), as this often coincides with spread widening.
Additionally, loans provide investors with better structural protection from economic weakness and/or issuer distress than the unsecured debt market, indicating that the current period of rising economic uncertainty is not an opportune time to trade down in the capital structure, particularly given the absence of incremental yield for doing so.
As mentioned, bank loans are typically more senior in the capital structure, taking precedence over most high yield bonds in the instance of a credit event by an issuer. This means senior loans theoretically have less credit risk than bonds issued by the same company.
At the same time, senior loans carry the potential to generate elevated levels of income to compensate investors for being deemed speculative grade credit.
Due to their seniority and security, senior loans tend to reduce volatility in a portfolio as their prices can be relatively stable compared to other securities.
Exhibit 4: Senior loans’ reduced volatility
Senior loans versus high yield bonds
The main differences between senior loans and high-yield bonds, are shown in Exhibit 5 below.
Exhibit 5: Senior loans versus high yield bonds
Credit spreads on senior loans are usually larger than investment grade bonds but smaller than high-yield bonds, as the greater yield versus investment grade reflects greater perceived credit risk of bank loans, while the slightly lower yield relative to high-yield is the result of bank loans’ higher position in the capital structure.
But right now, loans also offer a yield advantage over high yield bonds. Historically, the reverse has generally been true because high yield bonds carry additional risk relative to bank loans. However, bank loans have offered higher yields than high yield bonds since November 2018. For investors seeking income, we believe bank loans can offer attractive yield potential, especially in the current environment.
Exhibit 6: Yield advantage of high yield bonds vs. senior loans
Like high yield, senior loans have the potential to generate elevated levels of income because they are deemed to be speculative grade credit. But loans can generate that elevated level of income while providing a far lower duration than high yield.
Exhibit 7: Yield vs. duration
By bringing in duration and sitting higher in the capital structure, senior loans may be able to navigate late cycle credit dynamics better than a traditional high yield allocation.
On top of that, loans currently also offer a yield advantage over high yield bonds!
Debt covenants included in bank loans are important sources of protection for investors, as lenders can seek instant repayment of the loan if a covenant is violated. Most often, violation of a covenant also comes with a fee penalty that an issuer must pay to lenders along with the opportunity to renegotiate loan terms.
There are typically two types of debt covenants.
Incurrence covenants require the issuer to meet specified financial tests if the company wants to take a distinct action (examples would include paying an equity dividend or issuing additional debt). Maintenance covenants are more restrictive, compelling issuers to meet specified financial tests each quarter even if there is no specific action management would like to take.
Bank loans that are issued with only incurrence covenants and no maintenance covenants are classified as covenant-lite. This is a term getting a lot of publicity in recent years as covenant-lite loans represent an increasing component of the overall market. Covenant-lite loans now represent over 75% of new loan issuance, and a similar percentage of the outstanding loan market.
This means fewer restrictions on the borrower on how they use their current debt outstanding and the potential for issuance of even more debt.
While it is important to understand the specific covenants involved in any bank loan when investing, the mere presence of covenant-lite terms does not make a loan a bad investment. Most loans with maintenance covenants will never trigger a violation.
Historically, covenant-lite and full covenant loans defaulted at similar rates, although between the years of 2007-2012, defaults among covenant lite loans were actually lower than those with full covenants. The additional flexibility for issuers without maintenance covenants may have allowed borrowers to circumvent default. On the other hand, a lack of maintenance covenants can delay the inevitable in a truly bad situation and may lower the recovery rates for lenders.
Invesco Senior Loan ETF
The Invesco Senior Loan ETF currently yields 5.1% and the asset under management amount to almost $5 billion.
This ETF is based on the S&P/LSTA U.S. Leveraged Loan 100 Index. BKLN will normally invest at least 80% of its total assets in the component securities that comprise the Index. The Index is designed to track the market-weighted performance of the largest institutional leveraged loans based on market weightings, spreads and interest payments. The ETF and the S&P/LSTA U.S. Leveraged Loan 100 Index are rebalanced and reconstituted bi-annually, in June and December.
The majority of loans in BKLN are rated B and BB.
Exhibit 8: Rating allocation
The weighted average maturity is 5 years.
Exhibit 9: Maturity allocation
Exhibit 10: Top 10 holdings
History suggests that someday there may be a major, sustained flight to quality that will likely favor cash and Treasuries over riskier assets. But this stage of the credit cycle can last for years, and many investors need to earn return in the meantime. So, don’t dismiss senior loans. They merit a place in many bond portfolios as a diversifier and a volatility reducer. On top of that comes the nice yield. They currently even offer a yield advantage over high yield bonds while normally the opposite is the case. It might be a good idea to swap some rate risk (e.g. fixed rate treasuries) for the credit exposure offered by senior loans in your bond portfolio.