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ETF Specialist

Senior Loan Funds' Low Interest-Rate Risk, Enticing Yields Come With Risks

Investors should watch out for senior loan products' considerable liquidity risk and increasing credit risk.

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In today’s rising-interest-rate environment, senior loan funds’ low-interest-rate risk and enticing yields have made them alluring. Senior loans’ yields go up in lock step with short-term interest rates, offering an effective duration hedge, but they come with significant credit risks, as most of these loans are issued by companies rated below investment grade. Since 2010, their credit risk has gradually crept up. The relative debt loads to U.S. loan issuers’ cash flows had surpassed the precrisis high in 2016 and stayed at that level in subsequent periods through March 2018, according to S&P. The improving economic outlook and investor demand for yield facilitated this increasing debt load. Leveraged buyout activities and relaxing lending standards also contributed to this growth. On top of the credit risk, senior loans carry considerable liquidity risk.

Leveraged Buyout
The overall U.S. leveraged loan market leverage, measured by total debt/earnings before interest, taxes, depreciation, and amortization (EBITDA), is at its 14-year high, according to S&P. The preglobal financial crisis high was 4.9 times in 2007, which cratered to 3.7 times the following year. But this ratio slowly picked up and reached 5.0 times at the end of 2016, and it held steady at this level throughout 2017 and the first quarter of 2018. This elevated credit risk is partially offset by the issuers’ improved cash flow positions for debt service compared with 10 years ago. The average interest coverage ratio increased from 3.25 times to 4.75 times from 2007 to 2017, according to S&P. However, it is important to note that leveraged loan coupons float with interest-rate movements. If rates continue to rise, the interest coverage ratio is likely to decline.

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Phillip Yoo does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.