Investor Thinking - The investment opportunity in senior secured loans

Insight
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30 June 2017

The investment opportunity in senior secured loans

  • In the current low yield environment, institutional investors looking for attractive risk-adjusted returns and diversification opportunities in the non-investment grade credit universe could consider senior secured loans.
  • Senior secured loans can provide complementary exposure to existing high yield bond portfolios with a very limited sensitivity to a rise in interest rates.
  • Although different in terms of size, liquidity and maturity, overall, the US and European senior secured loan markets represent a combined €1,117 bn investment universe1 and are complementary to each other.

Senior secured loans—known also as bank loans or leveraged loans—are, along with bonds, the primary credit instruments that companies use for financing. Like bonds, loans offer investors direct exposure to corporate credit. Companies that typically issue loans are mid-to-largesized firms with above average gearing levels (they are therefore non-investment grade) that span a wide range of sectors. As with bonds, the primary risk when looking at loans lies in the creditworthiness of the borrower, i.e. the issuer’s ability to repay debt through cash-flow generation and/or refinancing.

Since 1998 US senior secured loans have returned an average of 5.54% p.a. to investors and European senior secured loans have returned an average of 5.33% p.a.2. Figure 1 shows that senior secured loans have delivered positive returns to investors each year over nearly two decades, with few exceptions.

We believe senior secured loans may offer investors attractive risk-adjusted returns in an environment of prolonged low yields as well as in an environment of increasing interest rates and positive economic growth.

Differences between senior secured loans and high yield bonds

Senior secured loans and high yield bonds differ in various regards. Senior secured loans are secured by the assets of the borrower, including but not limited to: share pledges, patents, real estate, equipment or intellectual property. They are senior in a company’s capital structure, meaning that loan holders are first in line for repayment in the case of a company’s sale or bankruptcy (Figure 2). The combination of the seniority and security leads to historical average recovery rates of 80.1% for senior secured loans vs. 41.1% for senior unsecured bonds3.

Senior secured loans are usually callable, as opposed to high yield bonds, meaning the borrower can decide to prepay the principal at par before the original maturity date. This prepayment can shorten the effective duration of loan portfolios.

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Source: Credit Suisse Western European Leveraged Loans Index (in €) and US Leveraged Loans Index (in $), AXA Investment Managers as at 31 March 2017. For illustrative purposes only. The figures provided relate to previous months or years and past performance is not a reliable indicator of current or future performance.