Bank Loan ETFs: More Competition In Red-Hot Sector

Includes: BKLN, SNLN, SRLN
by: Tom Lydon

Capitalizing on the growing popularity of high-yield investments with protection against interest rate risks, First Trust plans to launch an actively managed exchange traded fund designed to beat passive indexing methodologies.

According to a press release, the First Trust Senior Loan Fund (FTSL) will begin trading Thursday, May 2. FTSL will try to generate high current income and preserve capital through a diversified portfolio of senior floating rate bank loans.

The active managers seek to outperform the Markit iBoxx USD Liquid Leveraged Loan Index and the S&P/LSTA U.S. Leveraged Loan 100 Index.

FTSL has a 0.85% expense, which is slightly lower than an existing active senior loan ETF, but still higher than two passively managed funds that invest in senior loans.

Senior loans are private debt instruments issued by a bank and provide capital to companies that typically fall below investment-grade credit ratings. They pay higher yields to compensate investors for the extra risk. Nevertheless, according to a First Trust research note, senior loan default rates are currently below the historical average.

Since the securities are "senior" to other claims against the borrower, senior bank loans offer greater protection to investors in the event of bankruptcy. The assets also help diversify a portfolio as they show correlations to both traditional equities and bonds. Additionally, as a floating rate instrument, senior bank loans provide some cushion from rising interest rates.

Some income investors are taking a look at bank loan ETFs in place of high-yield corporate bonds, which have enjoyed a strong run.

"Most investors typically become interested in bank loans when interest rates are expected to rise," according to Morningstar analyst Timothy Srauts. "But with yields in the high-yield-bond sector near historic lows, bank-loan funds are looking more attractive on a relative basis."

FTSL is the second actively managed senior bank loan ETF to hit the market. State Street Global Advisors launched the SPDR Blackstone/GSO Senior Loan ETF (NYSEARCA:SRLN) earlier this month. SRLN has a 0.90% expense ratio.

"While an index-based senior loan ETF principally considers the market value of the debt issuance outstanding in its selection methodology, an actively managed ETF gives us the latitude to utilize our rigorous credit process in evaluating an individual company's ability to repay its debt, which we believe is paramount to driving attractive risk-adjusted and absolute returns over the long term," William Housey, CFA, Senior Vice President and Senior Portfolio Manager at First Trust, said in the press release.

Housey and Scott D. Fries, CFA, Senior Vice President, Portfolio Manager at First Trust, will manage the new ETF.

Instead of a cap-weighted approach, which could tilt the portfolio toward heavily indebted or overvalued borrowers, the active managers utilize a combination of fundamental credit analysis and macreconomic views to determine component holdings.

The First Trust actively managed ETF will also be going up against two passive senior bank loan ETFs: PowerShares Senior Loan Portfolio (NYSEARCA:BKLN), which tracks the S&P/LSTA U.S. Leveraged Loan 100 Index; and the Highland/iBoxx Senior Loan ETF (NASDAQ:SNLN), which tracks the Markit iBoxx Liquid Leveraged Loan Index.

The PowerShares BKLN has a 0.66% expense ratio and a 3.90% 30-day SEC yield. BKLN is the largest ETF in this category and has witnessed assets more than double since the start of the year, gaining over $2 billion in new inflows. The Highland SNLN has a 0.55% expense ratio and a 5.15% 30-day SEC yield.

Max Chen contributed to this article.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.