The tug-of-war between risk and return has never been as grueling as in recent years. Having seen what can happen to their account values when markets decline, investors have become increasingly concerned about preserving capital, yet still expect their financial advisors to deliver meaningful returns. Market volatility drove assets away from equities and into fixed income, but where can investors find yield in today’s low interest rate environment? And what will happen to their fixed income positions when interest rates ascend from their historic lows?

Many advisors have discovered an alternative to traditional fixed income securities in a once overlooked asset class. Senior secured loans represent a $1.1 trillion asset class that provides a form of debt financing for companies that may not have the ability or desire to issue bonds or sell equity. Instead they enter into five- to seven-year contracts with lenders, often from the institutional arena, to borrow money to finance their businesses. Borrowers use the loans to pay for expansions, fund acquisitions and for general business purposes, ultimately fueling economic and job growth. While senior secured loans tend to be used by private companies, many have substantial scale and size and are well-known businesses with successful operating histories.

Interest in senior secured loans has been increasing among advisors in part because they help to address two types of risks traditionally associated with fixed income securities – interest rate risk and credit risk. Let’s explore how senior secured loans can mitigate some of these concerns.

Floating Rates Hedge Against Rising Interest
With an estimated $12 trillion invested in corporate bonds today, interest rate risk is a hot topic for investors worried about inflation and interest rate increases. As an investment option, senior secured loans stand out among fixed income investments for a variety of reasons, one of the timeliest being that they have floating interest rates.

For those who believe rising interest rates are inevitable, floating rates offer welcome protection. Senior secured loans typically set their interest payments to automatically adjust with changes in market interest rates. When a loan is made, capital lenders negotiate an interest rate representing the sum of two components: the credit spread, which takes into account the creditworthiness of the particular borrower, plus the base rate, which represents the general level of interest rates in the economy. In the case of senior secured loans, lenders are paid a credit spread over a short-term base rate, typically pegged to the 3-month LIBOR (London Interbank Offered Rate). An uptick in LIBOR can trigger a higher interest payment, creating an interest rate hedge for lenders and investors.

The same cannot be said for more traditional fixed income securities, like bonds, that commonly pay a fixed interest rate. When market interest rates go up, bonds issued at lower interest rates become less valuable relative to new bonds issued at the prevailing higher rate – potentially resulting in losses. One way an investor can gauge their interest rate risk is by analyzing the duration of their fixed income portfolio. Duration is simply a measure of a security’s sensitivity to changes in interest rates. High yield bonds, for example, have a duration of 5 years on average, which means that if long-term interest rates go up by 1 percent, the value of a high yield bond falls 5 percent. In contrast, senior secured loans have an average duration of about three months, making them less exposed to changes in interest rates and a superior option for those investors concerned with interest rate risk.

Offsetting Credit Risks
Investors in senior secured loans essentially act as lenders and want to make sure that borrowers live up to their end of the deal and repay the principal that is due at the end of the loan. Three attributes of senior secured loans help mitigate credit risks. First, senior secured loans sit on an enviable perch at the top of the capital structure. When it comes time for a borrower to pay its debts, senior secured loan investors are generally first in line to be repaid. Second, senior secured loans are often collateralized or “secured” by assets (cash flow, inventory, equipment, real estate, etc.). If a company cannot meet its obligations, senior secured loan investors may be able to liquidate or take possession of the defaulted company’s assets. Lastly, the contract between a senior secured loan borrower and lender is governed by covenants that allow lenders to take pre-emptive steps if the borrower’s financial health begins to deteriorate. Historically, these combined attributes have allowed senior secured loans to recover approximately 80% of their principal value in the event of a default and exhibit the lowest loss rate of all corporate securities.

While senior secured loans contain mechanisms that can reduce risk, no investment is risk free. Companies that issue senior secured loans are often rated below investment grade and have few other options for obtaining credit. It requires expert asset managers to properly evaluate the many risks involved with investing in senior secured loans.

Opportunities For Investors
As the desire for yield and capital preservation has increased, so too has the value many investors and their advisors see in senior secured loans. This asset class represents a viable option for investors seeking to diversify their income streams and preserve the value of their investment dollars. Once relegated to the institutional investing tool kit, senior secured loans are now within reach of mainstream investors. Qualified investors can gain access to loans through mutual funds, ETFs and business development companies (BDCs). Each of these fund structures comes with its own set of risks, fees, strategies and investment time horizons. Advisors owe it to themselves and their clients to learn about these investment opportunities.

Michael Forman is the CEO and Zachary Klehr is an Executive Vice President at Franklin Square Capital Partners, a leading manager of alternative investment funds designed to enhance investors’ portfolios by providing access to asset classes, strategies and asset managers that typically have been available to only the largest institutional investors. The views expressed herein are for informational use only and should not be considered investment advice. An investment in senior secured loans may involve a high degree of risk. Investors should carefully consider such risks and consult their financial advisors for additional information concerning their specific situation. Franklin Square and its affiliates cannot be held responsible for any direct or incidental loss incurred as a result of any investor’s reliance on the opinions expressed herein. Franklin Square Capital Partners is not affiliated with Franklin Resources/Franklin Templeton Investments or the Franklin Funds.