Why senior secured loans are loved by bond investors

For more than a decade, the investment environment for bonds has been nothing short of odd. We have lived through 14 years of exceptionally low interest rates and the longest credit cycle in financial history. The risk landscape has been transformed and distorted, forcing bond investors to completely rethink how they look at bond risk.

The end of the COVID-19 pandemic brought about another seismic shift. We experienced the highest levels of headline inflation in 40 years. Central banks have started a cycle of interest rate increases – an event that had not taken place since before the Great Financial Crisis in 2008.

For bond investors, this headache could turn into a migraine. Hopefully, senior secured loans could be part of the cure.

Senior loans are investments rated below investment grade. These investments are speculative in nature and are considered to have a high degree of investment risk. Such assets have greater default risks, greater exposure to market volatility, and greater liquidity risks when compared to investment grade debt obligations.

We all know that traditionally banks make loans to businesses. In return, businesses secure those loans using inventory, property, equipment, and real estate. During the 1990s, banks started to increase their lending capabilities by syndicating these loans.

What this meant was that the bank was not the lender. The bank’s role was to arrange the structuring process and then find investors for these loans. These instruments became known as senior secured loans. 

They trade like bonds in the secondary market, but there are some differences. While senior secured bonds pay fixed coupons, senior secured loans pay floating rate coupons, which are made up of a fixed spread over a moving reference interest rate. In the past this was LIBOR, which is rapidly being replaced by the Secured Overnight Financing Rate (SOFR).

The fixed spread on a senior secured loan is set by the syndicating bank based on feedback it receives from investors on what is a suitable rate. For investors, a suitable rate represents the credit risk they are willing to take, or the risk premium that they want to be rewarded for holding the senior secured loan. Typically, this is assessed by a seasoned credit analyst who will look at the health of the company’s earnings and its corporate outlook to assess how easily that business can service these loans without defaulting.

These are often the same analysts that study high-yield bonds. This is because senior secured loans are usually issued by the same companies that issue high yield bonds.

It is true that senior secured loans are rated below investment grade by major credit agencies. However, this is often because the companies that issue them are highly leveraged on a relative basis. This can happen when the loan is being issued to finance an acquisition.

However, investors are compensated with a relatively attractive return versus other fixed income investments. This is also a fairly unique asset class, offering bond investors a very powerful strategic asset allocation tool during periods of market turbulence and inflation. That is why senior secured loans are loved by bond investors.

You need to remember that these are still loans, which makes them very different from bonds. Senior secured loans are secured by the assets of the borrower. Consequently, they have a more senior position in a company’s capital structure.

This means that as loan holders, investors in senior secured loans are paid first if a company goes bankrupt. This has a huge positive impact on the credit risk, which is one of the attractions for investing in them. Investors also benefit from higher recovery rates in the case of default because these loanss are secured by assets.

However, because senior secured loans are so different from other types of bonds in terms of their structure and covenants, their returns are less correlated to the rest of the bond universe, which is great for portfolio construction.

What senior secured loans offer is an alternative source of risk premium for bond investors. This can be particularly useful for portfolio construction. When added to a portfolio, they can help increase diversification and enhance the portfolio’s risk-return profile.

However, their most useful attribute is their ability to reduce duration risk. This is the risk associated with rising inflation and interest rates. It means that bond investors can strategically use senior secured loans to fight the risk of inflation. These are instruments that may offer attractive income on a real basis, regardless of the inflation environment.

Figure 1: History of the senior loan market

Senior loans date back to the late 1980s, when the market for high-yield bonds expanded in the US and institutional investors began to participate in the purchase of loans. Insurance companies and investment funds were among the first non-banks to become involved in the business. 

This development continued with the increasing consolidation of the US banking sector in the 1990s. Indeed, in the aftermath of the global financial crisis, structured vehicles – primarily collateralized loan obligations – became an increasingly important component of demand. The growth of this asset class was primarily down to the increasing involvement of non-banks, investment funds, and above all pension funds. 

Demand for the asset class among institutional investors has increased substantially with the ongoing development of research, trading, and pricing. The market for sub-investment grade loans is currently estimated at USD 1.4 trillion, thus outstripping the market for high-yield bonds.

There are two sets of investors that buy senior secured loans. The first set are the issuers of collateralized loan obligations (CLOs), which make up about 60% of the market. These are special purpose vehicles that are set up to hold and manage pools of leveraged loans to create a marketable security. This process is known as securitization. These CLOs can then be bought by other investors.

These investors are an important stabilizing force for the senior secured loan market. CLOs are lock-up structures, which means that they are less likely to sell during a correction, helping to lower market volatility.

The second set of investors, which are now growing in importance, are institutional investors such as high-yield bond funds, hedge funds, pension funds, and insurance companies. These investors tend to be more strategic and hold senior secured loans as part of a long-term strategic asset allocation strategy. They too do not tend to move in and out of the market rapidly, which also helps lower market volatility.

These investors also hold secured loans because, as mentioned, they are very useful in mitigating inflation. They help by lowering the overall duration risk of a portfolio and by providing a healthy yield that moves with interest rates.