The investor pitch for leveraged-loan exchange traded funds writes itself. They have appealing yields, given the environment – about 4 per cent. And they have defensive qualities. Interest rate risk and credit risk are lower than for, say, plain old junk bonds.

The pitch is working on someone. PowerShares Senior Loan ETF (BKLN) has $7bn in assets under management. Other leveraged-loan ETFs have about another $1bn or so.

Interest rate risk is low because loans have a yield set to a spread above the London interbank offered rate. If rates rise, the lender receives higher yields. And these loans are often senior in a company’s capital structure. If the borrower has credit problems, holders of the loans are at the front of the creditor line. In bankruptcy, recoveries on senior leveraged loans average about 70 per cent, according to the Loan Syndications and Trading Association. That is perhaps double the recoveries for the bonds found in the big, high-yield ETFs.

And returns have been good. The S&P/LSTA Leveraged Loan index, which underlies BKLN, returned about 5 per cent in 2013 when the Barclays US Aggregate bond index fell 2 per cent.

That all sounds great but there is a third risk: illiquidity. It may pop up less often than rate rises or credit degradation do but it is much nastier than either when it does appear. In 2013, leveraged loans traded roughly $2bn daily: not as much as, say, high-yield bonds, which trade three times as much, though not terrible. But it has been a sunny period of strong demand and low interest and default rates.

If interest rates rise and credit conditions worsen simultaneously, what happens at the edges of the credit markets is anybody’s guess. It has been a while since those two stresses were applied in tandem. Illiquidity is the risk ETF owners should think about first and last.

Email the Lex team in confidence at lex@ft.com

Get alerts on Exchange traded funds when a new story is published

Copyright The Financial Times Limited 2018. All rights reserved.

Follow the topics in this article