One lesser known area of the fixed income universe coming into focus is senior secured loans. What are these instruments and what role can they play in a portfolio?
Senior secured loans are secured debt instruments that rank senior in the capital structure of a company and pay a floating rate coupon. As a result, senior secured loans have the potential to provide downside protection as short term rates rise, diversification to a broader portfolio, and attractive returns with lower volatility relative to unsecured debt.
A closer look at senior secured loans
Senior secured loans are loans made to businesses with generally below investment grade credit ratings. They are senior instruments, secured by the debtor’s assets, and rank first in priority of payment in the capital structure, ahead of unsecured debt. As a result of their senior secured status, such loans have historically had lower default rates, higher recovery rates and less volatile returns relative to high yield corporate bonds.
The defensive characteristics of senior secured loans
Senior secured loans typically pay a cash coupon that resets in accordance with changes in short-term interest rates (LIBOR). The floating rate coupon can serve to neutralise the risk of rising interest rates on the price of the loan.
Possessing little interest rate sensitivity shields senior secured loans from duration concerns and makes for an investment that is defensive in a range of economic environments. If interest rates rise, the floating rate coupon of senior secured loans will also rise. Conventional bonds, alternatively, are exposed to interest rate risk (duration).
Attractive as interest rates rise
Unlike most fixed income bonds with low coupons and extended maturities, senior secured loans should perform well in the majority of rising rate scenarios. They can have very low or even negative correlation to fixed income securities in general and correlate moderately well with equities and economic growth. The floating rate feature of senior secured loans acts to buoy them against falling bond prices caused by rising rates. In a period of stagflation, the relatively rare but not unprecedented scenario in which inflation pushes up interest rates despite anaemic economic growth, the senior secured and floating rate characteristics of such loans can mitigate the risk of rising rates and/or deteriorating credit relative to their investment grade and high yield counterparts.
In addition, as previously noted, senior secured loans offer other attractive attributes such as enhanced portfolio diversification, collateral that provides downside protection relative to unsecured debt, seniority within the capital structure, lower volatility relative to high yield bonds, strong fundamentals and an attractive risk/reward proposition.
Particularly attractive in the current environment
In steady and uncertain markets, senior secured loans tend to offset interest rate risk and limit the interest-rate-driven price volatility inherent in a fixed income allocation. In the current low interest rate environment, with rate rises on the horizon, this property becomes increasingly more valuable. To a greater extent than high yield bonds, thoroughly researched senior secured loans have in the past buffered fixed income portfolios against rising interest rates. Intensive credit research is crucial, because not all issues are created equal, particularly in the case of highly levered firms. In our view, fundamental analysis is one of the surest ways of minimising credit risk while optimising the benefit to overall asset diversification.
While senior secured loans do not provide a perfect interest rate hedge to a fixed income portfolio, their attributes in a diversified asset allocation model are compelling.
