Senior loans, currently the highest-yielding bonds, witness substantial inflows in tracker funds.
In September, ETFs focusing on senior loans attracted over a billion dollars in investments, marking the highest influx since June 2021. The surge in popularity can be attributed to the outstanding performance of US bonds, particularly the Invesco Senior Loan ETF (ticker: BKLN). This ETF comprises structured bank loans with low credit quality but significant coupons.
In September, BKLN achieved an impressive total return of nearly 10 percent, surpassing the relatively stagnant performance of the overall US bond market represented by the Vanguard Total Bond Market Index Fund, according to Bloomberg Intelligence data.
Specialist asset class appeal
Pieter Laan, head of external manager selection at IBS Capital Allies, said senior loans present an appealing opportunity to enhance fixed-income portfolio yields and diversify bond holdings. However, asset managers haven’t actively engaged with this asset class. The lack of attention can be attributed to its specialized nature, akin to asset-backed securities. «Few players operate in this field, and most solutions lack daily liquidity. Additionally, investors frequently turn to high-yield bonds to augment yield and risk in their portfolios. The unfamiliar often goes unloved,» explains Laan.
Notably, senior loans currently offer higher coupons than high-yield bonds for the first time in 25 years. These loans hold a higher position in the capital structure, providing security by enabling investors to fall back on a company’s assets if a loan faces repayment challenges.
One significant difference from high-yield bonds is the variable coupon rate of senior loans. A rise in the risk-free interest rate translates to increased income for investors but also heightens the risk, particularly in economic slowdowns. The Federal Reserve’s senior loan officer opinion survey indicates a record low percentage of banks willing to lend due to shifting economic conditions.
Shift towards fixed-rate bonds
Winnie Cisar, a researcher at Creditsights, emphasizes that while investing in floating-rate bonds was wise in 2022 and 2023, the future preference should lean towards fixed-rate bonds. «The loan market is fundamentally of slightly lower quality than the high-yield bond market,» notes Cisar. Rising interest rates could hinder the refinancing capabilities of floating-rate issuers.
Laan acknowledges the inherent risk in this segment of the bond market. However, he reassures investors that the secured nature of senior loans historically ensures they recover 60-65 percent of their investment in case of company default and bankruptcy.
«The annual loan default rate has averaged 3 percent for the US market over the past 25 years, and in recent years, it’s been around 1.5 percent. With rising interest rates and a less favorable economic environment, we anticipate a default rate of 3 to 5 percent. Nevertheless, considering the yield to maturity exceeds 10 percent, investors can still secure a robust return,» Laan concludes.