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Senior Loan ETFs: The Best Bet for Rising Rates?

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Interest rates have been inching up ever since the Federal Reserve officials began the ‘taper’ talk, even though there is a lot of disagreement among the market participants about the likely time of start of ‘tapering’. The benchmark 10-year interest rate yield is now ~2.90%, a sharp increase from a low of 1.61% reached earlier this year. (Read: 3 Sector ETFs to profit from rising rates)

Although many investors tend to shy away from bond ETFs in the current rising rate environment, there are still a number of appropriate choices in the fixed income ETF world. These products can help investors reduce their dependence on equities, while providing a nice regular payment above most stocks. At the same time, unlike most other fixed income instruments, these products do not lose value when the rates increase.

In the junk bond space, there is an often overlooked slice of the market that could be an interesting choice for those with minimal levels of exposure to the market. This corner has been the senior loans market, which provides investors some shelter from higher interest rates with above-average yields. (Read: Junk Bond ETF Investing: Is It Too Late?).

What is a Senior Loan?

Senior loans, also known as leveraged loans, are private debt instruments issued by a bank and syndicated by a group of banks or institutional investors. These provide capital to companies that have below-investment grade credit ratings. In order to compensate this high risk, senior loans usually pay higher yields.

Since the securities are senior to other forms of debt or equity, senior bank loans offer protection to investors should there be a credit event, especially if the loans are secured by property, equipment or other company items. As a result, default risk is low in this type of bonds, although these loans are issued on higher risk companies.

Further, senior loans are floating rate instruments and provide protection from rising interest rates. This is because senior loans usually have rates set at a specific level above LIBOR and are reset every three months, which help in eliminating interest rate risk (read: Time to Buy Floating Rate ETFs?).

Thanks to this, senior loans could be a nice mix between high income and lower interest rate sensitivity making them ideal investments for many. Further, they have low correlations with most other asset classes and could add diversification benefits to the portfolio. Thus, senior loan ETFs have gained immense popularity in recent months. The space has already proven to be a solid choice for yield without taking on too much interest rate risk.

Investors seeking decent yield in the current interest rate environment and willing to take some additional credit risk could play with senior loan ETFs analyzed below.

PowerShares Senior Loan Portfolio Fund (BKLN - Free Report)

The fund tracks the S&P/LSTA U.S. Leveraged Loan 100 Index which acts as a benchmark for the largest institutional leveraged loans based on market weightings, spreads and interest payments. The ETF holds 132 securities in the basket with the vast majority maturing between one and 10 years.

With the average days to reset being just over 37, interest rate risk is minimal. Though senior loans account for a hefty 89% of the assets, high yield securities also make up for the remaining portion in the basket (read: HYLD: Crushing the High Yield ETF Competition).

The ETF debuted in March 2011 and is relatively expensive when compared to other ETFs focused on the low end of the debt market. The current expense ratio is 66 bps a year, which is thrice the low cost junk bond ETFs. However, the product enjoys heavy liquidity with average daily volume of roughly 2 million shares, suggesting no additional cost for the fund.

Though BKLN provides exposure to intermediate term securities, it has seen an amazing surge in popularity so far in 2013. The fund has gathered over $2.2 billion so far this year, propelling the total asset base to $5.3 billion. The ETF has added 0.57% in the year-to-date time frame while yields 3.57% in annual dividends and 3.86% in SEC 30-Day yield.

SPDR Blackstone/GSO Senior Loan ETF (SRLN - Free Report)

This is the first actively managed ETF for senior loans and provides investors with current income, along with the preservation of capital. It does not track an index but will instead seek to beat the Markit iBoxx U.S. Leveraged Loan 100 Index through superior security selection (read: State Street Launches Senior Loan ETF).

This is done by partaking in credit analysis, and timely sales and buys of senior loans. For example, the active approach looks to acquire loans at attractive prices before adding those to an index, or find loans that are likely to be removed from a benchmark and then proactively sell them before being kicked out of an index.

Overall, the fund holds 98 securities and charges 90 bps a year in fees, a bit higher than the two passively managed counterparts. Average days to reset is nearly double than the ultra-popular BKLN (see more in the Zacks ETF Center).

The ETF has seen great deal of investor interest since its debut in Apr 2013 and has attracted roughly $493 million in AUM. Trading volume is also solid with more than 84,000 shares per day.

Highland iBoxx Senior Loan ETF (SNLN - Free Report)

Launched in Nov 2012, this fund seeks to match the price and yield performance of the Markit iBoxx Liquid Leveraged Loan Index, before fees and expenses. The ETF has reached $105 million in total asset base.

The product is cheap relative to other options in the space, charging investors 55 bps a year in fees. Average days to reset are 37 and yield to maturity is 5.32% (read: Buy These ETFs to Profit from The Great Duration Rotation).

SNLN is trades in average daily volume of roughly 35,000 shares. This suggests a wide bid/ask spread, probably increasing the total cost for the fund. The ETF added 1.02% year-to-date and pays a decent 1.23% in dividend per annum.

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