Bank Loan ETFs Primed For Interest Rate Rise

March 6, 2015 Rick Roberts

The interest rate countdown clock has officially begun. When the Federal Reserve Open Market Committee meets in mid-June, investors may see the first hike in U.S. interest rates in nearly a decade. In anticipation, fixed-income investors have been seeking out bonds and bond funds that wont lose value as interest rates rise.

One popular choice is the PowerShares Senior Loan Portfolio ETF (BKLN), which has more than $5 billion in assets under management.

This ETF, along with the First Trust Senior Loan Fund (FTSL), Highland iBoxx Senior Loan ETF (SNLN) and the SPDR Blackstone/GSO Senior Loan ETF (SRLN), focus on the distinct category of senior bank loans, most of which are issued by large, privately held firms, or companies such as H.J. Heinz and Neiman Marcus that are owned by private-equity shops.

Private-equity firms love to issue senior loans because they are a key source of low-cost, variable-rate debt. These loans can extend up to six or eight years, but many are called by the issuer long before then. Senior loans generally are pegged to the London Interbank Offered Rate (Libor), plus an additional three to five percentage points. The Libor three-month rate is currently 0.25 percent. They appeal to investors because their yields rise in tandem with benchmark interest rates, and thus dont lose value like fixed-yield debt does.

Any successful investment niche invariably attracts new competition, and ETF sponsors looking to launch a new entrant must offer either a cheaper alternative or one that can deliver greater returns. ETF provider AdvisorShares, in tandem with bond specialist Pacific Asset Management, is aiming to pursue the latter route in this niche sector.

The AdvisorShares Pacific Asset Enhanced Floating Rate ETF (FLRT) began trading on February 19 and carries a category-high 1.10 percent expense ratio. Among existing competitors, the FTSL fund carries an expense ratio of 0.85 percent, SRLN charges 0.70 percent and BKLN is at 0.65 percent, while SNLN carries a category-best 0.55 percent expense ratio.

We think we can provide a better total return on an after-fee basis, says Bob Boyd, managing director of Pacific Asset Management. His team has been investing in senior banks loans for nearly a decade, and believes theyve cultivated an approach that will yield outperformance over time.

Boyd isnt keen to see the fund compared to the popular PowerShares fund, which passively owns a basket of loansthe current total is 119tied to the S&P/LSTA U.S. Leveraged Loan 100 Index. Boyd posits that approach is too risky. You dont want to own everything, he says.

All of these ETFs tend to focus on loans issued by firms with mid-tier credit ratings (mostly BB and B rated), though the FLRT fund managers can broaden their scope from AAA to C when they deem it warranted.

Issuers in that BB to B range are typically not perceived as investment grade, but the focus on senior loans rather than subordinated bonds means that a portfolio stocked with these securities is less risky than high-yield bond funds. Still, credit quality analysis is an essential factor in loan selection.

Indeed some senior loans will default, which can drag down the broader funds performance. The key in this area is to avoid losses, and weve been successful in that respect, Boyd says, speaking to his firms track record. The fund currently holds senior loans issued by firms such as Burger King, Community Health and Albertsons. We tend to focus on large, stable billion-dollar firms, he says.

Of course not losing money is not the same thing as making money, so the AdvisorShares fund employs additional twists. First, the ETF will sometimes use borrowed funds in an attempt to leverage up returns. The fund managers can take on 130 percent leverage (i.e. deploy 130 percent of the funds associated assets under management), though that leverage figure currently stands at around 105 percent.

Second, Pacific Asset Managements credit analysts will establish a broad economic framework and then seek out loans conforming to that macro view. That approach is expected to lead to fewer loan defaults in the portfolio, which Boyd thinks will lead to better returns.