US interest rates are moving higher, but investors are still looking for alternative income generating assets. A popular solution for income investors who want to manage rising interest rates has been bank loans or senior loans. An asset class was made increasingly available by exchange-traded funds such as PowerShares Senior Loan Portfolio (NYSEArca: BKLN) being bank loan funds.
Variable-rate bonds and senior loans are unique because their returns are tied to a benchmark like LIBOR, rather than being predetermined. The loans are also higher on the capital structure than other unsecured commitments. Some also have a floor to ensure you get a reasonable return even if interest rates are low. Their coupon rates are usually reset every 90 days, resulting in a shorter duration than three months.
So, a way to look at an ETF like BKLN and that is passively managed. This is the largest of the exchange traded funds investing in the US. This ETF allows investors to keep their cake and eat it too. BKLN, which tracks the S & P / LSTA US Leveraged Loan 100 Index, reduces interest rate risk and has a 30-day SEC return of 2.72 percent. This is a good income level for lower interest rate risk.
This does not mean that BKLN and senior loans are free lunches
There are no free loans offered. Although the interest rate risk is low, the credit risk is high. Most of the fund’s assets are invested in loans with an investment grade credit rating. As of February 2017, the average default rate from 2002 to 2017 for högavkastningslån 3.3 percent, according to JPMorgan and S & P. The minimum initial spread is 125 basis points above Libor for a loan should be included in this fund. Thus, despite the short term, the fund offered a return of 2.7 percent in February 2017.
A well-known criticism of high-yield bond funds is that they can be vulnerable in liquidity terms. While that view has met some well-founded opposition to this, especially traditional junk bonds. The liquidity problem is to a lesser extent about senior loans, but it clearly exists. The liquidity of senior loans ”creates challenges for the fund. There is a liquidity match as the fund must provide daily liquidity, as there is no set time limit for settlement of senior notes. In fact, it took an average of 17 days to complete a higher loan transaction during the second quarter of 2016, says Morningstar.
Bank loan funds use various measures to manage liquidity risk
BKLN allocates approximately 10 percent of its assets to cash and more liquid high-yield bonds. The rest of the assets are skewed towards the most liquid and largest loans. It also has a credit for being able to handle emergency liquidity events. Investors have still raised $ 4.8 billion to BKLN over the past year, more than double the inflows with the second largest of PowerShares ETFs.