Rising Rates Hurt Most Bond ETFs. This Senior Loan ETF Gets a Raise Instead

Floating-rate debt comes in several varieties, and I like to think about the major categories according to the credit risk you’re accepting. At the conservative end are Treasury floating-rate notes, backed by the U.S. government and designed to reset their coupons alongside short-term Treasury rates. Move up the risk spectrum and you get floating-rate investment-grade corporate debt, where investors take company-specific credit risk in exchange for additional yield.

At the riskiest end are senior loans, also called leveraged loans or bank loans. These are typically floating-rate loans made to companies with below-investment-grade credit ratings. They’re somewhat analogous to private credit because buying and managing individual leveraged loans isn’t particularly practical for ordinary investors.

The market is institutionally oriented, individual loans can be difficult to access, and analyzing the underlying borrowers requires considerably more credit work than buying Treasuries. That’s why senior-loan ETFs have become a useful way to package the asset class, with the SPDR Blackstone Senior Loan ETF (SRLN) among the largest actively managed options.

How Senior Loans Work

Senior loans occupy a particularly interesting position in the corporate capital structure. These loans are generally secured by company assets and sit relatively high in the repayment waterfall. If a borrower defaults and enters restructuring or bankruptcy, senior secured lenders generally have priority over unsecured bondholders and equity owners when available assets are distributed.

That doesn’t guarantee repayment. Collateral can be worth less than expected, and heavily indebted companies can have insufficient assets to make every creditor whole. But seniority and security can improve potential recoveries compared with junior claims from the same borrower.

The other defining feature is the floating coupon. Rather than paying a fixed interest rate like a conventional corporate bond, leveraged loans are commonly priced at a spread above a short-term benchmark such as the Secured Overnight Financing Rate, or SOFR. A loan might, for example, pay SOFR plus a specified number of basis points.

Some loans also incorporate SOFR floors. If the benchmark falls below that floor, the reference rate used to calculate the coupon doesn’t decline any further. That can provide some protection to lenders when short-term rates fall substantially. When short-term rates rise, however, the mechanics become particularly attractive. SOFR generally moves higher as monetary policy tightens, which eventually resets the interest received from floating-rate loans upward.

That’s very different from a conventional fixed-rate high-yield bond. If market rates rise, the bond’s fixed coupon doesn’t change. Instead, its market price generally needs to fall to make its yield competitive with newly issued debt. Senior loans consequently have much lower interest-rate sensitivity than conventional fixed-rate bonds. But that doesn’t make them low risk.

Credit risk is the major concern. These are predominantly loans to below-investment-grade borrowers, which can have substantial leverage and weaker balance sheets. A recession can simultaneously hurt corporate cash flows, increase defaults and cause credit spreads to widen. That’s why I’d view senior loans primarily as a credit investment with low duration rather than a substitute for safe short-term bonds.

SRLN Currently Yields 6.55%

SRLN provides actively managed exposure to this market rather than mechanically tracking a leveraged-loan index. As the sub-adviser, Blackstone can perform credit analysis, select individual loans and adjust the portfolio as it sees changes in borrower fundamentals and relative value.

You pay dearly for that management. SRLN charges a 0.70% expense ratio, which is expensive compared with broad Treasury and investment-grade bond ETFs. The compensation is a much higher yield. As of Sept. 22, SRLN had a 6.55% 30-day SEC yield.

I wouldn’t compare that 6.55% directly with a Treasury yield without accounting for credit quality, though. A majority of SRLN’s portfolio sits deep within below-investment-grade territory:

The distributions also don’t receive the same tax advantages as Treasury interest or qualifying municipal bond income. Corporate loan interest is generally taxable as ordinary income, making SRLN potentially more attractive inside a tax-advantaged retirement account for investors who otherwise face high marginal income-tax rates.

So far, at least, SRLN’s active management has earned some justification for its relatively high fee. Since inception, the ETF has modestly outperformed the Morningstar LSTA U.S. Leveraged Loan Index on a cumulative total-return basis. I wouldn’t assume that advantage persists. A 0.70% annual expense ratio creates a meaningful hurdle that SRLN needs to overcome year after year.

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