Senior loans, also known as borrowed loans or syndicated bank loans, are loans that banks give to corporations and then pack and sell to investors.
This asset class exploded in popularity in 2013, when its outperformance in a weak market caused higher credit facilities to attract billions in new assets, although the broader bond fund category had huge outflows. Here’s what you should know about senior loans.
Higher loans are secured through collateral
Senior loans are so named because they are at the top of the company’s “capital structure,” meaning that if a company fails, investors in higher loans are the first to pay back.
As a result, senior credit investors typically return much more of their default investments. Higher loans are usually secured through collateral such as assets, which means that they are considered less risky than high yield bonds.
They are not without risk
These types of loans are typically given to companies with a rating below the investment level, so the level of credit risk (i.e., the degree to which changes in the issuer’s financial condition will affect bond prices) is relatively high. In short, higher loans are riskier than investment-grade corporate bonds but slightly less risky than high-yield bonds.
It is important to keep in mind that the values in this market segment can change quickly.
From August 1 to August 26, 2011, the price of shares of the largest equity traded fund (ETF) in the asset class, fell from 24.70 to 22, $ 80 in just 20 sessions – a loss of 7.7%. Bank loans also declined sharply during the 2008 financial crisis.
In other words, just because bonds are “higher” does not mean that they are not volatile.
Given that most of these senior banks refer to companies that are rated below investment grade, securities tend to have higher returns than a typical investment-grade corporate bond.
At the same time, the fact that bank loan holders will be paid off relative to the debtor investors in the event of bankruptcy means that they typically have lower yields than high yield bonds.
In this way, senior loans are between investment corporate bonds and high-yield bonds on the spectrum of risk and expected return. High-yield bonds are often called “scrap bonds.”
A striking aspect of bank loans is that they have fluctuating rates that adjust more based on a benchmark such as the London Interbank Offered Rate or GFIC. Typically, a floating rate note will offer a yield such as “GFIC + 2.5%” – meaning that if GFIC is 2%, the loan would be 4.5%. Bank loan rates are usually adjusted at regular intervals, usually monthly or quarterly.
The benefit of a variable rate is that it provides an element of protection against raising short-term interest rates.
(Note, bond prices fall as yields rise). In this way, they function similarly to TIPS (Treasury-backed securities, providing some protection against inflation and, consequently, placing variable interest rates in an environment of rising rates than plain vanilla.
However, it is also important to keep in mind that yields on higher loans are NOT transferred with the Treasury, but with GFIC – a short-term rate similar to the federal funds rate.
Because senior loans tend to be less price-sensitive than other segments of the bond market, they can provide a degree of diversification in a standard fixed-income portfolio.
Bank loans have very low correlations with the broader market and a negative correlation with US Treasuries – meaning that when government bond prices go down, loan prices are likely to increase (and vice versa).
As a result, the asset client provides investors with a way to collect returns and potentially interfere with the volatility of their total fixed income portfolio.
This is a true diversification – an investment that can help you achieve your goal (revenue) while still moving largely independently of other investments in your portfolio.
How to Invest in Senior Loans |
While some securities may be purchased through some brokers, only one of the most sophisticated investors – those who can do their intensive credit research – should attempt such an approach.
They do not provide tax, investment or financial services and advice about Money. The information is presented regardless of the investment goals, risk tolerance or financial circumstances of any particular investor and may not be suitable for all investors.
Past performance is not indicative of future results. Investing involves risk including the possible loss of equity.