• 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.
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.
What this means in effect is that one of the only ways for UK investors to access the asset class is through institutional mandates or through a closed-ended fund. Institutional mandates tend to have very large minimum investments so for a retail financial adviser the closed-ended fund route is likely to be the most appropriate. There are currently several closed-ended funds offering exposure principally to senior loans, and these include Alcentra European Floating Rate Income and HarbourVest Senior Loans Europe, which are focused on European senior loans, and NB Global Floating Rate Income. All of these funds are listed on the London Stock Exchange and are members of the Association of Investment Companies.
• What are the risks?
Because senior secured loans tend to be issued by companies with sub-investment grade credit ratings there is inherently a higher risk of default than with, say, developed market government bonds. However the loan holders are first in the queue for repayment in the event of a default and because the loans are secured on the company’s assets the likelihood of total capital loss is lessened. As with many assets the loans market is cyclical. In a cyclical trough, characterised by weak economic conditions, defaults tend to rise, prices fall and there is little new issuance. However the loans market tends to rally in anticipation of improving economic fundamentals and this early part of the cycle can provide capital growth opportunities as assets re-rate rapidly.
• Where are the opportunities?
Because the market is cyclical it tends to favour those with more of an active credit risk management and opportunistic investment approach – simply tracking the market would be dangerous particularly in the late cycle when good credit analysis is paramount. The closed-ended fund structure is better suited to an opportunistic style as being ‘fearful when others are greedy and greedy when others are fearful’ (to borrow a phrase from Warren Buffett) is easier to achieve with a stable pool of assets rather than with one that ebbs and flows with investor sentiment.
Jim Shanahan is manager of JP Morgan Senior Secured Loan Fund
Key points
■ Senior secured loans are loans made to companies that are generally rated below investment grade (BB or below) by credit rating agencies.
■ The principal payment is fixed but the interest coupon fluctuates based on changes in short-term interest rates.
■ As with many assets the loans market is cyclical.
