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Senior-loan funds shield investors from rising rates

But be aware of the risk-reward trade-offs.

Wendy Stein 7 November, 2017 | 6:00PM
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With the risk of further interest-rate hikes on the horizon, income-producing investments that combine high yields with low interest-rate sensitivity are an attractive proposition. One asset class that can check both boxes is senior loans, also referred to as floating-rate bank loans.

Canadian retail investors can add this asset class to their portfolios via either a mutual fund or an exchange-traded fund. Over the past several years, we've seen a growing number of fund managers competing in this specialty category. (See table.) For high-net-worth individuals, alternatives also include the newly launched Sprott Canadian Senior Debt, a fund sold via offering memorandum to accredited investors.

Unlike a bond that has a fixed coupon payment, the coupon payment of a senior loan resets when interest rates change. This means that, unlike conventional bonds, senior loans have next to no interest-rate risk. As a result, their value tends to remain relatively stable in a rising interest-rate environment.

But there are risk-reward trade-offs. Investing in senior-loan funds means accepting risk related to credit, liquidity and potentially currency.

There's credit risk because senior loans are considered high-yield debt. However, their "senior" status means that they are often secured with corporate assets such as equipment or real estate. In theory, this provides more protection if things go wrong than you'd get with a high-yield bond.

Secondly, bank loans have liquidity risk because they aren't as easy to buy and sell as to conventional types of corporate debt. Also, the settlement process for senior loans takes much longer.

Thirdly, there's also currency risk for Canadian investors. This asset class, like high-yield bonds, is predominantly a U.S. one. The companies doing the borrowing are mostly American, and the loans are denominated in U.S. dollars. For retail investors, the exceptions are funds whose managers hedge their foreign currency exposure.

Fund companies and ETF providers generally market their products as offering a hedge against rising rates, helping to protect portfolio values in rising rate environments. They are not marketed as short-term parking lots for cash, nor should they be, given the other risks involved.

On the risk-reward spectrum, senior-loan funds generally yield higher income but with higher credit risk than a mainstream investment-grade bond fund. Compared to high-yield bond funds, senior-loan funds can be expected to generate less income, but with less credit risk.

In considering whether to invest in senior-loan funds, history provides answers to two key questions. First, how have senior loans performed during periods of rising and falling interest rates? Secondly, how have they done during adverse credit-market conditions?

Since this is a relatively new asset class in Canada we can't use the fund-category average for analysis. It wasn't until 2015 that were there enough funds to warrant a category. Moreover, the only funds in the category that predate 2013 are Invesco Floating Rate Income and BMO Floating Rate Income, both of which were launched in 2005.

Because of the lack of Canadian track records, the CSFB Leveraged Loan Index, the most widely used benchmark, serves as a proxy for analysing the asset class. Though it's a U.S. index, there are parallels between the U.S. and Canada since both countries have experienced rising interest rates in the recent past.

First the good news. Since 1993, senior loans have delivered positive returns, in U.S.-dollar terms, in all but two calendar years. And in 2015, one of the two down years, the CSFB benchmark was down a mere 0.38%.

As for the downside, investors in senior loans suffered devastating losses during the financial-crisis year of 2008, when the CFSB index plunged 28% in U.S.-dollar terms. Despite their "senior" status, senior loans lost more that year than high-yield bonds.

For Canadian investors in senior loans, shifts in currency exchange rates are another important consideration. For example, when rate increases caused the bond universe to fall in value in 1994, 1999 and 2013, senior loans generated positive returns in U.S. dollars. However, converting the return of the senior-loan benchmark to the Canadian dollar wipes out the gain in 1999 and adds three more down years.

On a positive note, having U.S.-dollar exposure through senior loans can at times work in favour of Canadian investors. Converting the U.S.-dollar return to Canadian dollars reduced the 2008 loss to 11%, compared to a loss of 28% in U.S. currency.

Today there are 158 share classes in the category, offered by AGF, BMO, Canoe, CIBC, Fidelity, IA Clarington, Invesco, Mackenzie and Scotiabank. Most senior-load funds actively manage currency risk or take it off the table completely with fully hedged or U.S.-dollar versions. Only BMO, Invesco and Mackenzie offer Series D funds for the do-it-yourself investor.

The table below shortens the 158 to a representative subset of funds available to retail investors through fee-based accounts. In terms of performance, Mackenzie and AGF's U.S.-dollar options take the top spots over the year-to-date and one-year time periods but are among the worst performers over the three-year time period. Fidelity and CIBC’s Canadian-dollar options offer the best performance over the three-year period.

Name Assets
($Mil)		 MER 3 Yr
Return		 Inception
Date
AGF Floating Rate Income F 509.88 1.32 3.32 05/01/2012
AGF Floating Rate Income (USD) F 407.69 1.32 -1.09 06/24/2013
BMO Floating Rate Income F 48.28 0.86 2.49 08/16/2005
BMO Floating Rate Income (USD) F 38.61 0.86 -1.93 07/05/2006
Canoe Floating Rate Income F 70.02 1.09 6.09 08/15/2013
Canoe Floating Rate Income F Hedged 70.02 1.09 2.14 08/14/2013
Fidelity Floating Rate Hi Inc F 276.98 1.02 8.18 10/16/2013
Fidelity Floating Rate Hi Inc (USD) F 221.47 1.02 3.52 10/16/2013
IA Clarington Floating Rate Inc (USD) F 859.78 1.16 -0.67 01/02/2014
Invesco Floating Rate Income F 325.29 1.10 3.89 01/31/2005
Invesco Floating Rate Income (USD) F 260.10 1.10 -0.59 01/25/2005
Mackenzie Floating Rate Income F 579.22 0.99 4.76 05/09/2013
Mackenzie Floating Rate Income (USD) F 463.14 0.99 0.23 05/09/2013
Manulife Floating Rate Income F 212.43 1.01 3.05 08/19/2010
Manulife Floating Rate Income (USD) F 169.85 1.01 -1.52 08/19/2010
Quadrus Mac Floating Rate Income H 579.22 1.13 4.60 07/07/2014
Renaissance Floating Rate Income F 926.74 1.08 7.86 09/19/2013
Renaissance Floating Rate Income (USD) F 719.05 1.08 3.23 09/23/2013
As of Oct. 30, 2017. Source: Morningstar

In the ETF universe, only the PowerShares ETFs aim to replicate the performance of an index. PowerShares offers three currency options for exposure to a U.S. ETF that seeks to replicate the performance of the S&P/LSTA U.S. Leveraged Loan Index by investing in its largest 100 loans. First Trust Senior Loan (CAD-Hedged) (FSL) and Horizons Active Floating Rate Senior Loan (HSL) are both actively managed.

Name Ticker Assets ($Mil) MER Inception
Date
BMO Floating Rate High Yield ETF ZFH 498.00 0.45 02/10/2014
FT Senior Loan ETF CAD Hdg Adv FSL.A 1.00 1.52 08/27/2013
FT Senior Loan ETF CAD Hdg Comm FSL 208.00 0.95 08/27/2013
Horizons Active Floating Rt Sr Ln ETF E HSL 80.00 0.95 10/14/2014
Mackenzie Floating Rate Income ETF MFT 231.00 0.75 04/19/2016
PowerShares Senior Loan ETF BKL.F 81.00 0.81 04/13/2012
PowerShares Sr Ln ETF BKL.C UnH CAD Inc BKL.C 0.00 - 02/05/2017
PowerShares Sr Ln ETF BKL.U USD Inc BKL.U 0.00 - 02/05/2017
As of Oct. 30, 2017. Source: Morningstar

Yet another variation on investing in bank loans is that of BMO Floating Rate High Yield (ZFH). Unlike its peers, it does not invest directly in senior loans. Instead, it employs a combination of 90-day treasuries and derivatives to achieve its objectives. Its approach has worked well; it is the top performing ETF over three years and trails only the top performing Mackenzie ETF over the year-to-date and one-year periods.

However, despite in most cases their higher MERs, the top active mutual funds outperformed the top ETFs over the year-to-date, one-year and three-year periods.

Should senior-loan funds have a place in your portfolio? To date, we haven't seen a sustained increasing interest-rate environment during which senior loans and similar strategies, and the mutual funds and ETFs that invest in them, could have demonstrated their potential value to a fixed-income portfolio. And, as we presumably move through a normal economic cycle in the coming years, senior-loan defaults will inevitably rise if economic activity weakens.

There may be a case for an allocation to senior loans in your portfolio, depending on your target asset allocation and how much exposure you already have to natural hedges to interest-rate risk, like equities. If you are looking only to reduce interest-rate risk, consider senior-loan funds that hedge their currency exposure.

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About Author

Wendy Stein

Wendy Stein  Wendy Stein is a product manager at Morningstar Canada. She manages products for investment research, portfolio construction and retirement planning. Before joining Morningstar in 2010, she worked as a product manager in the mutual- fund industry for Invesco and Manulife in Canada and Legg Mason in the UK.

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