In a persistently low interest rate environment, such as we have been experiencing, investors have had few options on the fixed income side of their portfolios to generate a high level of income without assuming significant interest rate risk. For over 30 years, interest rates have been in a secular decline, leading to the strong performance of traditional long-duration fixed income securities.  Faced now with the prospect of an increasing interest rate environment, advisors would be well served to consider a less traditional fixed income alternative: senior secured floating rate loans. Over the past 16 years through 9/30/13, the senior loan asset class as represented by the S&P/LSTA Leveraged Loan Index has demonstrated positive returns in every year, with the exception of 2008, which was challenging for many asset classes.

Senior loans, also called bank loans, are a form of below-investment grade debt financing used by public and private companies and are also often used by private equity firms to finance acquisitions (leveraged buyouts). There is significant overlap among the companies that issue senior loans and high-yield bonds, however, senior loans offer several distinct advantages.

The first thing to consider is that, although these loans are categorized as below-investment grade, they are “secured” by the issuing company’s assets. (Below-investment grade securities are referred to as “high-yield” or “junk” securities.) In the event that the borrower cannot meet its financial obligations, the lender may be able to take possession of the company’s assets to secure repayment. Bank loans occupy the “senior” position in the borrower’s capital structure, meaning that in the event of a payment default, these senior creditors get paid ahead of all junior creditors.

Senior secured loan agreements may also contain financial covenants tied to anticipated financial metrics of the underlying company.  These financial covenants are essentially an option to “re-price risk” when a covenant default is near or has been reached.  If the borrower projects a certain level of cash flow or leverage (examples of financial covenants) in the future and they fail to deliver, they can come back to lenders to ask for forgiveness and negotiate an “amendment” to the original loan agreement. Lenders will usually agree to modify the loan, but the new terms often include a “re-pricing of risk”, either in the form of a fee or a higher interest rate on the loan.  Importantly, financial covenants have become less frequent or less restrictive on new senior loan issuance.  However, it is important to note that even the best financial covenant package doesn’t protect against a weak underlying business.  Cash flow of the underlying company and asset value are far more important in determining the ultimate recovery of a defaulted company.  Therefore, while the lack of financial covenants on new issues is worth noting as it may lead to more volatility in the underlying asset class when compared to history, a rigorous selection process in terms of the portfolio construction is paramount.

One particular advantage of senior secured loans, especially in the context of our current interest rate environment, is that unlike bonds which typically have a fixed coupon for the entire term, senior loans pay a floating rate. With bonds, if market interest rates rise, older bonds will be less valuable than newer issues that come with higher interest rates. The rate on senior loans is typically LIBOR-based and resets, on average, every 60 to 90 days, which allows the investor to participate in the upside of rising short-term interest rates, thereby reducing exposure to interest rate risk.  Moreover, in the current persistently low short-term interest rate environment, senior loan lenders have required that senior loans include LIBOR floors, thereby setting a minimum level of LIBOR from 0.75 percent -1.25 percent.  While these floors will result in a lag in terms of the benefit received from rising short-term rates, they have provided the benefit of insulating income during this period of anemic LIBOR rates.

In terms of where we sit today in both the economic and interest rate cycles, investing in the senior loan asset class may be appropriate. Historically, the single most important factor driving returns for below-investment grade investments, whether senior loans or high-yield bonds, has been defaults. The long-term default average for senior secured loans is approximately 3.5 percent (for the period March 1999 – September 2013 according to J.P. Morgan), however, at the end of the third quarter of 2013 the default rate was running at approximately 2 percent. Historically, a slow growth economic environment (GDP growth of 0-2 percent) has been an attractive time to lend money to below-investment grade companies. Corporate fundamentals, in general, are sound and companies have been operating with caution in terms of how they deploy their capital. In fact, a large portion of the senior secured loans issued this year were for refinancing, in an effort to extend debt maturities and reduce interest costs, which is indicative of companies making sound business decisions that will have a positive impact on their cash flow, and ability to repay debt. 

Continued modest growth in the overall economy combined with a low default rate, good corporate health and attention to fundamentals should continue to drive performance of the senior secured loan asset class, while at the same time generating attractive income. Moreover, with the potential for increasing interest rates looming on the horizon, the floating rate nature of senior loans could prove to be a worthy addition to a traditional fixed income allocation for many investors willing to bear the risks of investing in below-investment grade securities.

William Housey is the Senior Portfolio Manager for the First Trust Advisors Leveraged Finance Investment Team, which had approximately $1.1 billion under management or supervision as of September 2013.  William has 16 years of investment experience and has extensive experience in the portfolio management of both leveraged and unleveraged credit products, including senior loans, high-yield bonds, credit derivatives (CDS/LCDS) and work-outs/corporate restructurings.