Senior loans, a previously obscure segment of the bond market, have suddenly become the newest hot investment in fixed income. So far in 2013, the PowerShares Senior Loan Portfolio (NYSE:BKLN) has hauled in over $1.78 million in new assets — ninth highest among all ETFs year-to-date.

So is it time for income investors to add this sector to their portfolios?

Senior loans — also known as bank loans, syndicated loans, or leveraged loans — are private loans from banks to companies that are packaged, securitized and sold in the public market. Senior loans are high in the capital structure, meaning investors are ahead of the owners of plain-vanilla bonds in the event of a bankruptcy.

The types of companies represented in the asset class tend to be smaller and of lower credit quality, similar to what would be found in a high-yield portfolio. The holdings list for BKLN provides an example of the kind of companies represented in this market segment.

The Pros and Cons of Senior Loans

Right now, investors are being drawn by two key features of the asset class.

First, senior loans offer a high yield compared to other segments of the bond market. As of April 17, the 30-day SEC yield on BKLN stood at 3.95%, ahead of government bonds, higher-rated corporates and most segments of the investment-grade market, but below the yield on high-yield bonds.

Second, most senior loans have floating rates that reset on a monthly or quarterly basis. This has made the asset class hugely popular with investors, many of whom are looking for a way to invest in bonds without exposing their portfolios to interest-rate risk — or more specifically, to the long-anticipated bursting of the bond-market “bubble.” In the past 12 months, BKLN has generated a total return of 8.1%.

Senior loans also offer another key feature for investors: diversification. According to the PowerShares website, senior loans had a correlation of -0.03 with investment-grade bonds (as represented by the Barclays U.S. Aggregate Bond Index) — indicating almost no relationship in the performance of the two asset classes.

With all of these features, it’s no wonder that senior loans have become so popular in recent months.

However, investors also need to be aware that the asset class carries above-average risk — something that might be lost on many given that the credit sector (i.e., corporates, high yield, senior loans, etc.) hasn’t experienced a major disruption in over a year now. During periods in which investors are more risk-averse, bank loans exhibit the same kind of performance characteristics as high-yield bonds.

In the late summer of 2011, for instance, higher-risk market segments tumbled on revived concerns about the European debt crisis. From July 29 through Oct. 4, the iShares High Yield Corporate Bond Fund (NYSE:HYG) returned -9.3% in sympathy with plunging stock prices. During that same interval, BKLN fell 7.4%.

This helps demonstrate that while senior loans might hold up better than high yield in periods of elevated investor risk aversion, they still have more than their share of downside potential in absolute terms. Also, they tend to have a high correlation with both stocks and high-yield bonds — as can be seen in the chart below — meaning that they won’t provide diversification to portfolios that are invested heavily in these areas.

With so much new money having poured into senior-loan funds in the past few months, it’s worth questioning whether the next market downturn will cause investors to flee from senior-loan funds, thereby exacerbating the selloff.

The Bottom Line

Senior loans can be thought of as “high yield lite” — lower yields, less upside potential and lower downside risk. The asset class indeed offers a number of attractive selling points for investors, not the least of which are their floating rates and ability to diversify traditional bond portfolios.

At this stage, however, investors need to make sure they understand the risks before chasing the hot money into funds such as BKLN.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.