Diversify your income portfolio with senior loans

Diversify your income portfolio with senior loans

Diversify your income portfolio with senior loans

by Christopher Doll, Vice President, Head of Product & Business Strategy, PowerShares Canada, Invesco Canada

In today’s low-yield environment, fixed-income returns are uninspiring. Many advisors are looking to diversify beyond traditional fixed-income asset classes, and senior loans are an attractive floating-rate option for some investors.

Today’s environment

Canadian corporate spreads have come down considerably since highs reached in February 2016 and are now sitting below 10-year averages. U.S. high-yield spreads have also come down during this time and are now below historic averages.1 In today’s low-yield world, investors are hungry for income and demand is outpacing supply – leading to a tightening of credit spreads. However, with mixed economic signals, weaker cash-flow fundamentals and political uncertainty across the globe, we may be entering a period in which we see spreads widening in the high-yield space. Generally speaking, widening credit spreads indicate growing market concern about the borrowers’ ability to service their debt. Narrowing credit spreads therefore indicate improving creditworthiness.

Currently, high-yield to bank loan spreads are tight, potentially favouring senior loans – high-yield spread over senior loans is now less than 1%. In addition, we’re seeing corporate balance sheets in the U.S. levering up again, as demonstrated by net debt/EBITDA (earnings before interest, tax, depreciation and amortization) data, as well as interest coverage ratios weakening. Profit margins are significantly weaker due to wage growth and the cost of interest, while delinquency rates are rising.1

With this as the backdrop, there is a strong case to be made for taking a more defensive stance with your high yield allocations by employing the potential benefit of senior loans.

Getting to know senior loans

Senior loans provide an attractive yield per year of duration – the underlying yield for each year of duration risk taken on. Duration risk is the sensitivity of a bond’s price to a one percent change in interest rates – the higher a bond’s duration, the greater its sensitivity to interest rates changes.

For example, as of May 31, 2017, the S&P/LSTA U.S. Leveraged Loan 100 Index, the underlying index for PowerShares Senior Loan Index ETF (BKL), provides a yield-to-maturity2 of 4.38% on a duration of 0.08 years, meaning roughly 54.75 % of yield per year of duration.3 By comparison, the FTSE TMX Canada Universe Bond Index offers 1.88% on a duration of 7.49 years, resulting in 0.25% yield per year of duration.4 These numbers represent the potential yield available to an investor for a given level of interest-rate risk – the higher the yield per year of duration, the less interest-rate risk an investor is required to take on to get more yield potential.5

What these numbers illustrate is the attractive yields that senior loans have provided despite lower spreads. Comparing these numbers to those for higher-yield bonds, where spreads are wider and yields have been higher, senior loans still come out on top. For example, the BofA Merrill Lynch US High Yield Bond Index yields 5.54% on a duration of 3.68 years, resulting in a much lower 1.51% yield per year of duration.1 Not only do senior loans provide attractive yields, but they also help avoid the interest-rate risk that high-yield bonds can present.

Senior loans and LIBOR

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