While recent economic data has pointed to a slowly improving labor market, there remains a large degree of uncertainty about the stability of the U.S. economy. Traditionally, investors have sought out Treasuries and other fixed-rate bonds in these times as a safe haven. However, with interest rates so low, do these fixed-rate investments provide an appropriate risk/return for investors? The recent rise in U.S. Treasury rates has caused some market strategists to call this the beginning of a secular bear market for U.S. Treasuries. As rates rise and investments in fixed rate securities decline in value, what is an investor looking for income and capital preservation to do? There is an asset class that offers investors relatively strong downside protection and a hedge against rising interest rates – senior secured loans.
What are Senior Secured Loans?
Senior secured loans, also known as bank loans or leveraged loans, are made by financial institutions to non-investment grade corporate borrowers. Companies may choose to borrow utilizing a senior secured loan to finance an acquisition, recapitalization, refinancing or for general operating purposes. Private equity investors will often use a senior secured loan to facilitate their acquisition of the equity interest in a company. While senior secured borrowers are usually private companies, most have substantial scale and size, and many are well-known names with very successful operating histories and a track record of profitability.
Floating Interest Rates
Senior secured loans generally have terms of five to seven years and a floating interest rate made up of a base rate, usually the London Interbank Offered Rate (LIBOR), plus a fixed spread. LIBOR is the rate of interest that large banks charge other large banks when they make loans to each other. The interest rate is called “floating” because it resets on a regular basis; if the base rate increases, the coupon payment for the loan will increase as well. Generally, the LIBOR component of the interest rate resets every one or three months, providing little lag to capture the benefit of rising rates.
Seniority & Security
Senior secured loans are “senior” because they usually comprise the most senior portion of a borrower’s capital structure. The interest and principal of the senior secured loan must be paid prior to payments made to any other creditors, and senior secured lenders are the first to be paid back in the event of default, ahead of all other outstanding debt or equity holders. These loans are “secured” because they have a first priority claim on the assets of the borrower. If the borrower were to default, the senior secured lender would receive all of the company’s cash flow and be able to receive all proceeds from the sale of its assets until it is paid back in full, at which point the other creditors would be able to make a claim on the borrower’s remaining cash flow or assets. The interests of the lender are further enhanced by covenants in the loan agreement that set boundaries for the borrower’s financial conduct and minimum standards for the borrower’s performance.
Low Correlation, Enhanced Stability
Given their historically stable prices over the long term and their floating interest rates, senior secured loans have exhibited relatively low volatility, resulting in a potentially attractive risk-adjusted return for investors. Senior secured loans have also shown low correlation to other asset classes, and thus can be utilized to lower the risk of a portfolio without sacrificing return. As measured by the Credit Suisse Leveraged Loan Index, senior secured loans can reduce a portfolio’s overall risk because they tend to perform independently of traditional asset classes, which can be extremely important when stocks and bonds suffer declines in value.
Hedging Interest Rates
When interest rates rise, senior secured notes provide protection because of their floating rate structure, but the yield could decline if prevailing market interest rates were to fall. However, given where rates are in the interest rate cycle, any meaningful decline in loan yields is highly unlikely for two main reasons:
- First, the interest rates for these senior secured loans are set as a spread added to LIBOR. Given that LIBOR is at historically low levels it is unlikely that there will be any further significant declines.
- Second, it will be highly unlikely for senior secured loan yields to decline due to structural reasons. As LIBOR dropped to historically low levels, many lenders instituted LIBOR floors to ensure their loans generated a minimum return. Many of these floors were set at one to two percent ensuring that, even if LIBOR dropped below the floor, a base rate of interest would always be earned.
How Best to Invest in Senior Secured Loans
Not all senior secured loan products are the same. Floating rate mutual funds may be limited by their mandate or be beholden to simply outperforming their index versus delivering the best risk-adjusted absolute returns for their investors. Daily liquidity loan funds are also most exposed to supply/demand factors in the market, buying when everyone else is buying and selling when everyone else is selling. Look for products that can continually offer shares, especially when yields are most attractive, with flexible investment structures that allow managers to invest in similar assets outside of their core strategy. Make sure the manager you select can invest in more than just a broadly syndicated bank loan. Find a manager with an established origination platform and one who has the capability to source proprietary deals. Often these types of transactions offer appreciably higher yield than can be found in the broadly syndicated loan market. Finally, look for managers with proven track records and the expertise and scale to outperform the increasingly indistinguishable single-category managers crowding the asset class.
Senior secured debt is an attractive asset class given the uncertainty surrounding the economy and the threat of rising interest rates. Notable attributes of senior secured loans include:
- Senior secured lenders are paid first because they have the highest claim on a company’s assets.
- Floating rates make senior secured loans one of the few credit instruments that perform well in a rising interest rate environment.
- Senior secured loans generate meaningful current income.
- Senior secured loans have low or negative correlation to most other traditional asset classes.