In praise of floating-rate senior secured loans

When interest rates rise, that’s when this asset class really begins to shine

Pity the poor income investor. While many have seen capital gains as their bonds have risen in price, yields have fallen through the floor. The continuing low-interest rate environment has made it very difficult to secure income from traditional income assets such as bonds.

This change means investors need to rethink their approach to income. Instead of building a “set it and forget it” portfolio of government bonds, income investors need to look at multiple income streams, without necessarily abandoning bonds altogether.

One stream worth taking a closer look at is floating-rate senior secured loans (“senior loans” for short). They’re an asset that has flown under the radar among the general population, but they’ve recently become quite popular with high net worth (HNW) individuals.

There are a number of good quality funds and low-cost ETFs that offer exposure to this space (either via U.S. dollars or hedged back to the loonie). With that in mind, here’s a quick run-down on this asset.

What are floating-rate senior secured loans?

“Floating-rate senior secured loans” are simply asset-backed loans issued by companies with below-investment grade credit ratings. They are “floating rate” because the interest owed “floats” up and down with broader-market interest rates. They are “senior” because they usually take priority over other loans in the case of default. And they are “secured” because unlike many other forms of lending, they’re backed by hard assets (factory equipment, real estate, etc.).

When interest rates rise, that’s when this asset class really begins to shine. In fact, in the past three periods when interest rates have risen (February 1994 to February 1995; June 1999 to May 2000; June 2004 to June 2006), senior loans have returned 10.39%, 3.93%, and 12.66%, respectively.

Protection from credit risk

Senior loans are usually made out to companies with below investment-grade credit ratings. So from one perspective, senior loans are “riskier” than government bonds and investment-grade corporate bonds. However, if a company runs into trouble, senior loans will usually be paid before bondholders, preferred shares or common stock.

In addition, if a company defaults, investors in senior loans will usually get more money back than other creditors. In fact, an ING Investment Management study found that between 1995 and 2011, the recovery rate for first-lien loans averaged about 71%. Compare that with high-yield bond investors, who typically got 44% of their money back.

Good hedge against interest rates

Unlike traditional bonds, the interest rate on senior loans is generally reset quarterly. This is usually expressed as a “reference” interest rate (generally LIBOR) plus a spread. So as the reference rate moves, the interest you receive will fluctuate. This can be very attractive in times of rising interest rates.

Lower correlation

Correlation is a measure of how often one asset class moves in the same direction (either positive or negative) as another. So, if you have two assets with a correlation of 1.0, it means the two assets move in lockstep with each other. A correlation of -1.0 means they move in equal but opposite directions.

Senior loans have a pretty low correlation with other assets. Since 2009, the S&P/LSTA Leveraged Loan Index has had a correlation of 0.59 with the S&P 500. Compare that with the Bank of America/Merrill Lynch U.S. High-Yield Master II Index, which had a correlation of 0.73.

I want to be clear here: senior floating-rate loans are not a replacement for traditional bonds. But they’re an asset class that’s worth exploring and one that’s under-represented in most investors’ portfolios. I would target an allocation of perhaps 10% to 15% of a total fixed income portfolio and consider them an excellent alternative to high-yield bonds. •

Thane Stenner (thane.stenner@richardsongmp.com) is the founder of Stenner Investment Partners within Richardson GMP Ltd. His column appears every two weeks.

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