Author: Matthieu Mougeot
In their “2018 Themes & Opportunities”, Mercer research teams identified rising central banks interest rates as a major theme for the coming future. Indeed the US Federal has led the transition from QE (quantitative easing) to QT (quantitative tightening) with a series of interest rates increases after almost a decade of monetary stimulus. The Bank of England followed in late 2017, and the European Central Bank has announced a reduction in the rate of asset purchases in 2018, paving the way for future possible rate hikes if the macro-economic environment continues to improve. Rising interest rates have a direct impact on fixed income portfolios, forcing investors to adjust them to this new environment. In order to minimize the direct impact of rising interest rates, few options are offered to investors. Among them, the most straightforward option is to reduce the portfolio duration. Allocating to floating rate assets directly helps reducing the duration. Senior secured loans are structured as floating rate and then can help achieve this goal.
Senior secured loans belong to the broader credit universe and are typically issued by non-investment grade companies. Despite this, they do offer more “security” versus other assets such as high yield bonds. Indeed the issuing company actually pledges some of its assets as collateral against the loan. This additional safety provides them with higher recovery rates than high yield bonds or other unsecured assets from non-investment grade borrowers. On top of being secured, loans are usually issued with a senior position in the capital structure.
Senior loans are not traded through standardized markets but are instead originated by banks. Companies use proceeds of these loans for a wide range of activities including: acquisitions, refinancing, or general activities. Contrary to regular bonds paying a fixed coupon, senior loan coupons are based on a floating rate (LIBOR or Euribor) plus the credit spread of the issuer. An important feature in the issue of senior secured loans is the use of covenants, aiming at reducing the risk that the borrower might not be able to repay the loan. There are two types of covenants: maintenance covenants (regular financial tests on the borrower such as leverage ratio or coverage ratio) and incurrence covenants (financial tests triggered by specific events such as additional debt issuance, acquisition…).
The senior loans market is most advanced in the U.S. and Europe, with total assets across the regions of around $1.2 trillion. Investors might track the evolution of the market through various index providers such as Standard & Poors or Credit Suisse. The market is mostly an institutional investors market, with the main investors being CLO or fund managers.
Senior secured loans have demonstrated attractive historical risk and return features, both from a relative point of view and from an absolute perspective. Since January 1999, U.S. senior loans have generated an annualized return of 4.8 percent with 6 percent annualized volatility (in USD), as measured by the S&P LSTA Leveraged Loan Index. Yearly returns have demonstrated a relative stability with only two negative returns for this index: 2008 (-29 percent) and 2015 (-0.7 percent). The maximum drawdown was around -30 percent, with the low point seen in December 2008. However, the recovery was relatively quick, as the index reached its previous peak again nine months later. From a risk-adjusted point of view, these figures compare favorably to high yield bonds, providing senior loans a better Sharpe ratio than high yield over different time horizons. On top of these risks and return characteristics, senior loans also provide interesting diversification benefits thanks to low correlation to both treasuries and investment grade bonds and medium correlation to equities (around 0.5).
Source: S&P LSTA in USD, Mercer Insight as of 30.06.2018
We should put a US HY Bond Index against these figures to show the superiority of SSL as mentioned in the text above
Since the financial crisis, ultra-accommodative central bank policies have led investors to diversify fixed income exposure in the search for yields. Now that interest rates are on the rise again (U.S.), fixed income portfolios need to be adjusted to this new environment. Given the correlation features described above, senior secured loans have the potential to provide further diversification benefits from a traditional fixed income allocation. Additionally, thanks to their floating nature, senior secured loans exhibit an ultra-low duration, typically below three months. As a result, their addition into a fixed income allocation may improve the current (and future) yield profile while at the same time reducing the overall duration of the portfolio.
Senior loans are generally non-investment grade instruments and in certain cases not even rated. From a credit risk perspective, they would be comparable to high yield bonds. That said and given their “secured” nature, senior loans do have a better recovery value than high yield bonds. While the average recovery value for high yield bonds has historically been around 40 percent, that of senior secured loans has been slightly below 70 percent% (67 percent in the U.S., 70 percent in Europe according to Moodys). The credit risk premium is the main source of additional yield from senior secured loans. When available, credit ratings provide already an interesting assessment of this risk. However, a proper analysis of a company’s financial ratios and its ability to repay its debt is of crucial importance when investing in senior secured loans. Additionally, a detailed analysis of the covenants attached to the loans is necessary. Most of the current and new issues of senior secured loans are “cov-lite” which means they have few covenants (mostly incurrence covenants). Default rates are broadly comparable with those of high yield bonds from a historical point of view as long-term average default rates have been around 3.5 to 4 percent in the U.S. and around 2.3 to 2.5 percent in Europe (source: Credit Suisse). As such, the credit risk underlying senior secured loans is correlated more to equity risk than is the interest rate risk.
From an operational point of view, as senior secured loans are not traded on a standardized market they might not be as liquid as more standardized instruments, especially in times of market stress. That said, even if bid/ask spreads widened during the financial crisis, bid quotes were still received. Current bid/ask spreads and trading volumes provide the market with sufficient liquidity.
Given the specificities and operational complexity of the asset class, the best approach to invest into senior secured loans is through specialized managers. These have a proper understanding of the asset class both from an investment and from an operational point of view. Investor trends and outlook
According to Mercer’s 2018 European Institutional Investors survey, around 3 percent of the respondents have an allocation to senior secured loans, which represents around 4 percent of their total portfolio. In Switzerland, senior secured loans are classified as “alternative investments” for pension funds under BVV2 rules. As a result, it’s more difficult to track the average allocation of Swiss pension funds. Discussions with our clients point to a growing interest in the asset class with either clients already invested in or clients/prospects considering adding the asset class to their portfolio.
Strategic allocation to growth-oriented fixed income (source: Mercer European Asset Allocation Survey 2018)
Mercer has attributed a current overall “neutral” rating to senior secured loans in its Dynamic Asset Allocation views. Given current yields and default rates in both U.S. and Europe, we do still see some value in senior secured loans. For Swiss investors however, the hedging cost from USD is an important item to consider when valuing the current attractiveness of senior secured loans on a hedged basis. From a macro point of the view, the global environment is still positive with the U.S. economy in particular riding a wave of positive economic momentum. This is positive for companies and hence for senior secured loans. The loan market continues to see healthy and growing issuance levels, both in the U.S. and in Europe. Over the medium-term, investors might consider the risk of approaching the peak of the credit cycle, which could lead to decreasing cash flows from companies and potentially increasing defaults rates (from current low levels).
Adding senior secured loans would help to further diversify fixed income allocations. Their inclusion should be well integrated in the fixed income component of the portfolio. From a client point of view, most of this activity has been focused on a broader sub-investment grade multi-asset approach, which makes sense in our view. Loans make up a large part of these credit portfolios, but managers are also able to invest across the spectrum, investing in high yield, convertibles and in some cases emerging market debt. The client searches witnessed in particular in the loan market have generally come from larger clients and they have invested on a regional basis.
With more than 23,000 employees in 44 countries, Mercer operates in over 130 countries. In Switzerland, Mercer operates through Mercer Switzerland Inc. and Mercer Private Markets AG. Mercer Switzerland’s business activities focus on advising companies on all aspects of occupational benefits, investments, human capital strategies and employee remuneration/mobility.
Mercer relies on the expertise of more than 2’200 investment specialists worldwide, including local specialists servicing our clients. Our research team comprises more than 140 analysts focusing on manager search, specialized by asset classes. Senior secured loans are covered by our dedicated Fixed Income boutique. Mercer currently tracks more than 130 specialized loan managers in its Global Investment Manager Database (GIMD), with more than 50 managers rated by our analysts (across U.S., Europe and Global).
Should you consider creating a senior secured loans allocation in your portfolio, or should you need a review of your existing managers, Mercer capabilities would be very well positioned to assist you.