JThe Federal Reserve is two hikes away from its interest rate tightening cycle, and more – perhaps many, many more – could be on the way with inflation remaining elevated.
So bond investors are feeling considerable pain. The widely followed Bloomberg US Aggregate Bond Index is down 10% year-to-date, and one of the most talked about stories is that almost all fixed-income exchange-traded funds are in the red This year.
Bank loan funds are included in this group, but Invesco Senior Loan ETF (BKLN) deserves some credit, as it beats “Agg” by 450 basis points year-to-date. With BKLN in the red, many investors are embracing bank loans for above-average income levels and inflation-fighting ability.
“Many investors are turning to bank loans, also known as floating rate loans, which are debt securities whose coupon is linked to a short-term interest rate such as LIBOR or SOFR. Given the variable-rate nature of the asset, adding bank loans to your portfolio can reduce duration and increase potential income as the Fed seeks to continue raising short-term interest rates to combat the recent surge in inflation,” according to BlackRock research.
As noted by the asset manager and confirmed by BKLN’s performance history of more than 11 years, bank loans are among the fixed income instruments that are sustainable when interest rates rise. Moreover, it is one of the bond segments with positive correlations with inflation.
With a bank loan, an investor’s results are determined by credit spreads, floating rates tied to LIBOR or SOFR, capital appreciation, or a combination of the three.
“The ‘floating’ coupon feature reduces interest rate sensitivity for bank loans, which has contributed to the historical outperformance of asset classes against fixed income assets in rising rate environments,” adds BlackRock. “The ‘float’ component of a bank loan resets periodically and will dictate when investors realize the benefits of rising rates. Coupon rates are initially set when a bank loan is issued, consisting of a benchmark interest rate (historically LIBOR and, in the future, SOFR) plus a credit spread.
BKLN, which tracks the S&P/LSTA US Leveraged Loan 100 Index, holds 138 bank loans that are generally linked to three-month LIBOR.
These fixed income assets are typically used by rogue issuers, as underlined by the fact that 95% of BKLN’s holdings are rated BBB, BB or B. However, investors are compensated for this risk with a 30-day SEC yield of 3.41%, and business default rates are currently low.
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