Fixed Income  

Catch the early cycle

A form of private debt financing, they are more popular in the US and prevalent in the institutional market, but retail investors are able to invest in them as well.

• What are senior secured loans?

Senior secured loans are loans made to companies that are generally rated below investment grade (BB or below) by credit rating agencies.

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Senior secured loans make up the first tier of a borrower’s capital structure. They are typically secured by the operating assets of the borrowing company and rank first in priority of payment in the capital structure, ahead of junior loans and unsecured debt such as high-yield bonds. The leveraged loan market traces its origins to the securitisation market of the 1980s. Through much of the 1980s and 1990s large banks tended to retain on their balance sheets large proportions of the loans they made and syndicate only a small amount to other institutional investors.

In the late 1990s banks began syndicating loans more broadly to institutional investors attracted by the loans’ floating rate income and lower credit volatility. In the following decade the market expanded, became more liquid and began to function more like its high-yield bond counterpart. The investor base expanded beyond commercial banks and today more than half of the leveraged loans in issue are held by a broad range of institutional investors including insurance companies, mutual funds, pension funds and hedge funds.

• How are they different from other debt investments?

Generally speaking with a bond both the interest coupon and the principal at maturity (that is the capital that investors get back) are fixed.

For a senior secured loan, the principal payment is fixed but the interest coupon fluctuates based on changes in short-term interest rates, usually three-month Libor. When interest rates go up the current income received from a senior secured loan goes up and, generally speaking, the value of the principal tends to remain constant in the absence of deteriorating credit fundamentals.

Senior loans offer little duration risk because of their floating-rate structure which means they are less exposed to the trajectory of interest rates in general. The floating-rate coupons can benefit investors in a rising rate environment and can help to mitigate inflation risk.

• What are they good for?

The first thing to note about senior secured loans is that as non-investment grade investments they tend to offer attractive headline yields to investors.

Protection

However, as noted before, in addition to offering high headline yields, senior loans also offer an element of protection against rising interest rates, meaning they are less vulnerable than many other assets to a wind-down in quantitative easing programmes and rises in interest rates.

• How can investors access them?

Senior secured loans are better known among US investors than in the UK. This is probably because senior loans are not permitted investments under the European directives on Ucits which applies to open-ended investment companies and some societe d’investissement a capital variables.