Attractive yields and controlled volatility. Sounds great, doesn't it? Barings sets out the case for senior secured loans.

Barings, the investment firm, examines the market for global senior secured loans. These are debt instruments that offer yield advantages – an obvious attraction – with relatively low volatility over time. Given market gyrations, it is easy to see how such a mix appeals. This news service is happy to share these comments with readers. The usual health warnings apply: we do not necessarily endorse all views of outside contributors and invite readers to respond. Email the editor at tom.burroughes@wealthbriefing.com

In the low-yield environment of recent years, many investors have found it challenging to meet their yield targets. While additional yield has historically been achievable by taking on added risk, investors may be hesitant to add too much risk to their portfolios, especially as the economic cycle matures. In this environment, senior secured loans may be an option worth considering, as the asset class offers a unique blend of attractive yield potential with some protection against both credit and interest rate risk.

Senior secured loans are commonly issued by below-investment grade companies and can be used for a range of purposes such as financing acquisitions, refinancing existing debt and supporting expansion plans. The loans are underwritten by a lead bank and syndicated (or sold) to other banks and institutional investors. They pay a floating interest rate - a base rate (LIBOR), plus an additional fixed coupon - to compensate for the credit risk of lending to a below-investment grade company.

Example: Interest rate paid by senior secured loan borrower

Base rate: LIBOR of 2.5 per cent + fixed coupon/spread: 3.5 per cent = Total Rate: 6.0 per cent.

At a high level, senior secured loans have the potential to provide attractive risk-adjusted returns and other portfolio benefits, including:

-- Credit risk protection through capital structure seniority; some degree of asset-backing and covenant restrictions; hedging against rising interest rates; and diversification benefits/low correlation to equities and other traditional asset classes.

Key characteristics
Capital structure seniority: Senior secured loans are typically senior to other outstanding debt, including high yield bonds, in an issuing company’s capital structure. This seniority means that the loan’s interest and principal payments are paid before other creditors receive payment. In the event of a default, senior loan holders also typically get paid back ahead of bondholders, equity holders and other creditors. More junior in the capital structure, equity and high yield bonds can provide a cushion against losses for loan investors (Figure 1).

Security: Senior secured loans are backed by collateral. This security provides investors with some degree of credit risk protection as secured loans typically have first-priority claim on a borrower’s assets in the event of default.

Covenant Restrictions: Investor interests are further protected by covenants, which are contractual restrictions within the loan’s credit agreement that set minimum standards for a borrower’s financial conduct and performance during the term of the loan. For example, the borrower may have limitations on the ability to incur additional debt and pay dividends if they are not meeting certain financial requirements.

While there is concern in the market regarding an increase in covenant-lite transactions, we don’t believe this is necessarily as worrisome as some investors believe. Covenant-lite does not mean the absence of all covenants, rather it refers to loans that lack maintenance covenants, or covenants that require a borrower to meet minimum levels for financial metrics, such as debt-to-earnings before interest, taxation, depreciation and amortisation, at regular intervals. 

Based on our observations, there is little data showing that covenant-lite loans lead to lower recoveries. Rather, recoveries are all about the underlying quality of the business. Larger, more established companies tend to have more tools at their disposal to help avoid losses - they may be able to sell non-core business, for example - which has historically led to relatively high recovery levels. With this in mind, as larger companies enter the market, it is not unusual to see some document flexibility, as these tend to be better quality companies. With smaller businesses and less liquid businesses, higher standards of protection may be more critical.

Defaults in reasonable territory despite market volatility
Because senior secured loans are issued to below-investment grade companies, investors may be concerned about the potential for defaults. However, outside select industry sectors that continue to face headwinds (retail and energy), defaults overall remain below historical averages (figure 2). Because these loans are backed by collateral, they have also historically offered high recovery rates relative to other asset classes. For instance, as of February 2018, the recovery rate for senior secured loans was just over 80 per cent, meaning that in the event of default, for every $1,000 invested in senior secured loans over the period, an investor would have received (recovered) an average of $804 (Figure 3).

Attractive long-term returns
Over the last 20 years, leveraged loans in Europe and the US delivered positive returns over multiple credit cycles and economic downturns (Figure 4). The credit market dislocation in 2008 was the only market event during that period to have a significant negative impact on annual returns. Although both leveraged loan markets declined that year, they rebounded in 2009, posting record-high returns.

One of the main reasons that investors are drawn to senior secured loans is the potential for attractive spreads relative to other fixed income investments. Historically, US and European loans have offered an average spread of 460 and 507 bps over LIBOR, respectively (Figure 5).


 
How senior secured loans fit into a portfolio
Potential diversification benefits

One of the main reasons for including senior secured loans in a portfolio is the potential diversification they can add. This has been highlighted in recent years by their historically low volatility compared with other asset classes (figure 6) as well as lower correlation. In the context of a broadly diversified portfolio, this may potentially reduce the portfolio’s volatility and increase its long-term risk adjusted return potential.

Lower interest-rate sensitivity
Rising interest rates are a chief concern for most fixed income investors. There tends to be an inverse relationship between interest rates and the price of a fixed-income security - when rates increase, the value of fixed-income assets decreases, with the value of longer-dated bonds generally impacted the most. Senior secured loans, which offer floating rate coupons, can decrease sensitivity to short-term interest rates, and have historically provided some degree of protection against rising rates in the US and Europe (Figure 7).

Seeking relative value
A global approach to investing in senior secured loans can help investors capitalize on relative value opportunities in the asset class. For example, while the US and European senior secured loan markets both offer exposure to below-investment grade credit, the factors driving each market can vary. As a result, loans issued by the same company, with the same terms, can and have traded at materially different valuations if one is denominated in euros and the other in dollars.

A range of technical factors including new issuance volume, CLO issuance and flows in and out of retail mutual funds, can also create relative value opportunities. Changes in these technical factors can cause the market price of a security to decouple from its underlying fundamental value. Investors with long-term horizons may be able to capitalize on these market dislocations by buying securities that may be underpriced or by selling securities that may look rich relative to their fundamental value.

One example of such an opportunity occurred from mid-2015 through to the first quarter of 2016. As energy prices fell, US loan mutual funds, which have greater exposure to energy than European loans, experienced notable outflows. In addition, because there was no equivalent pressure on the European side - UCITS1 have only a very limited ability to hold loans - European loans fared much better than US loans, with the divergence in price based on technical factors rather than fundamentals. That was one period when US loan spreads decoupled materially from those in Europe, and it was an opportune time for active managers, like Barings, to take advantage of the relative value created.

Given how quickly market prices can react to changes in technical factors, a strategic global allocation to senior secured loans can facilitate the timely capture of evolving relative value opportunities in the global market. A number of technical factors can influence market prices and potentially lead to opportunities for active managers, including:

-- Retail mutual fund flows are an example of a market technical [movement] that can be driven by sentiment, which may have very little impact on the underlying financial health of companies issuing senior secured loans. That disconnect between sentiment and fundamentals can create attractive value opportunities. The fact that loans are not available as an investment option for retail investors in Europe is another factor that can drive differences between the markets; 

-- CLO issuance, as noted earlier, generates relatively steady demand for senior secured loans and can help mitigate the ebb and flow of retail demand for the asset class. This counterbalancing effect may help keep loan prices more stable than they might otherwise be. Of course, there are also times when CLOs may trade cheaply relative to their underlying loans, creating a specific value opportunity within this subset of the asset.

Conclusion
Senior secured loans can offer investors a unique blend of attractive yield potential and some protection against both credit and interest rate risk. In addition, the asset class can potentially provide: Some degree of credit risk protection, less volatility, attractive long-term returns, diversification benefits and relative value opportunities.

Further comments: 

Risk profile
While we see many benefits to investing in global senior secured loans, it is also important to consider the potential risks. Although this asset class is senior in the capital structure, investors may still be exposed to losses in the case of issuer defaults. Securities rated below-investment grade may have a greater risk of default and investors should consider such risks in the context of their overall investment portfolios. Investors may also be exposed to price fluctuations and/or losses, which can result from changes in overall market conditions or issuer-specific fundamentals.

At Barings, our primary goal is to deliver attractive risk-adjusted returns for our clients. To best manage risk, we conduct rigorous, bottom-up credit analysis in our initial underwriting process and regularly track key credit metrics to ensure the investment thesis for each credit that we invest in remains intact.

What are LIBOR floors and how will they impact loans going forward?
A LIBOR floor sets a minimum base rate to be paid on a floating-rate instrument, in this case a senior secured loan. Following the global financial crisis, as interest rates fell to historically low levels, the base rate component no longer offered investors an attractive return. Consequently, LIBOR floors have become common features of newly issued loans. 

Currently, loans with LIBOR floors may be particularly beneficial in Europe, given their potential to enhance spreads in regions with lower rates. Going forward, rates in the US and Europe will likely rise at different times and at different paces. As such, the presence of LIBOR floors must be considered as it will impact how quickly a rate rise will be reflected in a loan’s coupon payment.

Senior secured loans by other names
The following terms are also used to describe senior secured loans:

-- Bank loans (the loans are underwritten by a lead bank and syndicated to other banks); 
-- Floating rate loans (the interest rate on the loan is not fixed; it typically resets every three months in line with changes in market interest rates); and 
-- Leveraged loans (when a company borrows, it increases the leverage on its balance sheet).