As a Fed Rate Hike Looms, Investors Turn to Select ETFs

By Tom LydonPoliticsFOXBusiness

With more expecting the Federal Reserve to begin another round of interest rate hikes as soon as December, fixed-income investors are shifting into senior secured floating-rate bank loans and related exchange traded funds to hedge against rising rate risks.

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The PowerShares Senior Loan Portfolio (NYSEArca: BKLN), the largest senior loan-related ETF on the market, has added $224.5 million in net inflows over the past week and attracted close to $1.5 billion in inflows over the past 90 days, according to Invesco PowerShares data.

The increasing influx in assets into the senior loan portfolio suggests that more investors are growing wary of a potential Fed rate hike and want to position their fixed income portfolios accordingly.

The World of ETFs...

Looking at the Fed-funds futures market, options traders were pricing in a 70% chance of a rate hike in December, compared to a 50% chance a month ago, according to the CME Group. Investors added to bets that the Fed will hike interest rates on strong economic data and upbeat commentary from policy makers.

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A rising interest rate would negatively affect bond funds as newer debt securities would come with a higher rate, making older bonds with lower yields less attractive. Consequently, bond investors may turn to senior loans as a way to mitigate the rate risks but still be able to generate attractive yields.

A senior loan is a private loan taken from an underwriting bank or a syndicate of lenders. The loans are secured in that they are backed by the borrowers’ assets, which act as collateral. If the borrower defaults, lenders have a senior claim on the defaulters’ assets. Moreover, senior secured floating-rate loans have, as their name suggests, a floating interest rate component, which fluctuates with market rates.

Since rates are typically reset once per quarter, senior loans typically have low durations - a measure of a bond fund's sensitivity to changes in interest rates. The floating-rate component also offer investors an alternative method of earning yields while mitigating interest-rate risk. Consequently, bank loans are seen as an attractive substitute to traditional corporate debt in a rising rate environment.

For example, the PowerShares Senior Loan Portfolio has an average 41.5 day to reset period – the average number of days until the floating component of the loans resets. The passively managed ETF is based on the S&P/LSTA U.S. Leveraged Loan 100 Index, which is designed to track the market-weighted performance of the largest institutional leveraged loans. The fund also comes with a 0.65% expense ratio and an attractive 5.20% 30-day SEC yield.

Along with BKLN, investors may look to the passive index-based the Highland/iBoxx Senior Loan ETF (NYSEArca: SNLN). SNLN tracks the Markit iBoxx USD Liquid Leveraged Loan Index, which consists of the largest, most liquid leveraged loans. SNLN has 31.7 days to reset and a 4.46% 30-day SEC yield. It shows a 0.55% expense ratio.

There are also two actively managed options, including the SPDR Blackstone/GSO Senior Loan ETF (NYSEArca: SRLN), which has a 41 days reset period, a more expensive 0.70% expense ratio and a 3.82% 30-day SEC yield, and First Trust Senior Loan ETF (NasdaqGM: FTSL), which has a 45.31 day reset period, a 0.85% expense ratio and a 3.72% 30-day SEC yield.

Potential investors should also be aware that the senior loan ETFs largely track speculative-grade debt ratings. While senior loans are rated below-investment grade, default rates on senior loans have historically been slightly below those of high-yield or junk bonds. Additionally, in the event of a default, investors are more likely to recoup losses, which may make the asset category less risky than high-yield, speculative-grade debt.

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