Senior Loans Are Secured by Collateral
Senior loans are so named because they are at the top of a company’s “capital structure,” meaning that if the company were to fail, investors in senior loans are the first to be repaid. As a result, senior-loan investors typically recover much more of their investment in a default. Senior loans are typically secured by collateral such as property, which means they are considered to be less risky than high-yield bonds.
Not Risk-Free
These types of loans are typically made to companies with ratings below investment grade, so the level of credit risk (i.e., the degree to which changes in the issuers’ financial condition will affect bond prices) is comparatively high. In a nutshell, Senior loans are riskier than investment-grade corporate bonds but slightly less risky than high-yield bonds. It’s important to keep in mind that valuations in this market segment can change quickly. From August 1 to August 26, 2011, the share price of the largest exchange-traded fund (ETF) that invests in the asset class, the Invesco Senior Loan Portfolio (ticker: BKLN), fell from $24.70 to $22.80 in just 20 trading sessions—a loss of 7.7%. Bank loans also fell sharply during the financial crisis of 2008. In other words, just because the bonds are “senior” doesn’t mean they aren’t volatile.
Attractive Yields
Since the majority of these senior bank loans are made to companies rated below investment-grade, the securities tend to have higher yields than a typical investment-grade corporate bond. At the same time, the fact that owners of bank loans will be paid back ahead of bond investors in the event of bankruptcy means they typically have lower yields than high yield bonds. In this way, senior loans are between investment-grade corporate bonds and high yield bonds on the spectrum of risk and expected yield. High yield bonds are often called “junk bonds.”
Floating Rates
A compelling aspect of bank loans is that they have floating rates that adjust higher based on a reference rate such as the London Interbank Offered Rate (LIBOR). Typically, a floating rate note will offer a yield such as “LIBOR + 2.5%”—meaning that if LIBOR were 2%, the loan would offer a yield of 4.5%. The rates on bank loans typically readjust at fixed intervals, usually on a monthly or quarterly basis. The benefit of the floating rate is that it provides an element of protection against the rising short-term interest rates. (Keep in mind, bond prices fall when yields rise). In this particular way, they function similarly to TIPS (Treasury Investor-Protected Securities), providing some protection against inflation. In consequence, floating-rate securities perform better in an environment of rising rates than plain-vanilla bonds. The combination of higher yields and low rate sensitivity has helped make senior loans an increasingly popular segment for investors. However, it’s also important to keep in mind that the yields on senior loans DO NOT move in tandem with Treasurys, but rather with LIBOR—a short-term rate similar to the fed funds rate.
Provide Diversification
Since senior loans tend to be less rate-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 U.S. Treasurys—meaning that when government bond prices go down, senior loan prices are likely to go up (and vice versa). As a result, the asset class provides investors with a way to pick up yield and potentially dampen the volatility of their overall fixed income portfolio. This represents true diversification—an investment that can help fulfill a goal (income) and yet move in a largely independent fashion from other investments in your portfolio.
How to Invest in Senior Loans
While individual securities can be purchased through some brokers, only the most sophisticated investors—those able to do their own intensive credit research—should attempt such an approach. Fortunately, there are plenty of mutual funds that invest in this space, a full list of which is available online. In addition, the Invesco Senior Loan Portfolio—the ETF mentioned previously—provides access to this asset class, as do SPDR Blackstone/GSO Senior Loan ETF (SRLN), Highland/iBoxx Senior Loan ETF (SNLN), and First Trust Senior Loan ETF (FTSL).
