Senior Loans represent an attractive investment opportunity in the current market environment. This segment of the market has a good deal in common with the regular High Yield Bond space, as both consist of debt issued by below investment grade (BB or lower) companies. But two key elements set Senior Loans apart from the broader High Yield space.
First, Senior Loans are senior secured debt, hence the “Senior” in the name. Thus, owning Senior Loans provides the investor with the opportunity to take a step up the capital structure versus owning typical High Yield debt, which provides greater protection in the event of a bankruptcy by the issuer. Representative holdings in the Senior Loan space include well recognizable names such as Tribune, Chrysler, Del Monte and Clear Channel Communications.
Second, Senior Loans do not have a fixed interest rate and are instead variable interest rate debt instruments. The interest rate is set by establishing the base floating rate (usually LIBOR) and then adding a fixed interest rate on top of the base floating rate. This rate is reset every one to three months on average.
Senior Loans have been a remarkably consistent performer during the post financial crisis period. This is largely the result of two forces. To begin with, the steady flow of monetary stimulus from global central banks including the U.S. Federal Reserve has provided a steady tailwind for the entire High Yield space including Senior Loans, as any sustained pullbacks have occurred during periods when the Fed was between balance sheet expanding monetary stimulus programs. Also, even with their variable rate, Senior Loans offer an attractive yield at 6.15% in an environment where income-seeking investors are thirsting for yield with base rates pinned near 0%.
At present, Senior Loans are attractively valued. For example, the PowerShares Senior Loan Portfolio (BKLN) currently offers a yield to maturity of 6.15% versus the iShares $ High Yield Corporate Bond Fund (HYG) at 6.01%. Thus, investors have the opportunity today to get paid +0.14% in yield for taking a step up to the senior level of the capital structure.
Senior Loans also provide an appealing hedge against a rising interest rate environment. While it seems unlikely today that we will see interest rates moving higher any time soon with the U.S. Federal Reserve committed to keeping interest rates at 0% for the foreseeable future, the potential continues to exist for an inflationary shock or some related episode to push yields suddenly and sharply higher. Thus, owning Senior Loans provides the ability to receive a higher level of income today while also protecting against a sudden rise in interest rates going forward.
With a +0.56 correlation to the U.S. stock market, Senior Loans provide the ability to experience stock like returns at a considerably lower level of risk, as the 0.89% standard deviation of weekly returns on Senior Loans is roughly one-third that of the S&P 500 at 2.55%.
Disclosure: I am long Senior Loans via the PowerShares Senior Loan Portfolio (BKLN)