Senior Secured Loans: Attractive Current Income Coupled .

Senior Secured Loans: Attractive currentincome coupled with a short duration profileand a history of low correlation of returnsBy Björn Wolber and Sanyog YadavIn briefSenior Secured Loans (SSL) provideinvestors with an attractive investmentopportunity: SSL pay a floating couponat a premium above a base rate, whichtranslates into a generally limited interestrate sensitivity. By being both “senior” and“secured”, SSL can offer mitigation ofdownside risk in the event of default. Basedon their unique investment profile, SSLshave provided low correlation to traditionalasset classes and thus delivered attractivereturns and risk diversification in the past.Investors are facing growing challenges in thecurrent capital market environment which ischaracterized by a mix of overall compressed riskpremiums, low-yielding ‘safe-haven’ investmentsand recurring high volatility. In this environment,it is challenging to make sustainable decisions inorder to reach the targeted returns.In our view, the current capital market environmentcalls for fundamental changes in asset allocationto allow for the long-term achievement of realreturn targets. Many of the most commonly usedfixed-income investments, such as high-qualitygovernment bonds, now generate low to negativereal returns. Consequently, modified durations ofthese investments have reached all-time highs andthus impose significant duration risk to investmentportfolios. While base rates across the G7 countriesare either negative or at historical lows, yield curvesin some countries have begun to steepen. At thesame time, global growth is still fragile and concernsover the future path of central bank activitiesand national fiscal politics remain. Against thisbackground, it remains hard to obtain resilientforecasts on future interest rate developments.To manage this uncertainty, we believe that a fixedincome allocation should be considered that enables1) a flexible response to future interest ratemovements and 2) automatic participation in futurerate hikes without diluting returns on investment.In the current market environment, Senior Securedloans (SSLs) can offer attractive features that maycater for the needs of investors: Attractive current income – independent frommarket environment Minimal duration risk – providing a hedge againstrising interest rates Historic record of low volatility of investmentreturns compared to traditional asset classes Good historic and current risk-adjusted returnprofile Implied comprehensive credit risk mitigationmechanism – senior in capital structure andsecured Low historical correlation of returns – providingpotential benefits from portfolio diversificationIn general, SSLs can offer a combination of attractivecurrent income coupled with a short duration profileand are largely an uncorrelated source of return.1Senior Secured Loans: Attractive current income coupled with a short duration profile and a history of low correlation of returns

1 Introduction to Senior Secured loansSenior Secured loans (SSLs) are privately arrangedloans issued to a consortium of banks and institutionalcreditors that provide companies with access to debtcapital. SSLs traditionally offer a spread over thereference rate, typically LIBOR or EURIBOR, makingthem ‘floating-rate’ instruments. The majority of thespread over the reference rate typically covers thecredit risk of the issuer.Generally, the borrowers are corporates and theloans are normally dedicated for corporate purposes(such as capital expenditure), M&A-relatedtransactions or refinancing debt. Loans typicallyhave a credit rating below investment grade.Nonetheless, their special credit risk mitigationmechanisms (e.g. comprehensive collateral packagessuch as share pledges, seniority in the company’scapital structure and comprehensive financialcovenants) rank SSLs at the top of a company’scapital structure (figure 1). Seniority in thecompany’s capital structure effectively means thatthe SSL i liveredannual returns above 4% in about 71% of allcalendar years. Similarly, the monthly figures forthe Credit Suisse Western Europe Leveraged LoanIndex were highly consistent: Over the last 19 years,80% of monthly returns were positive. Over thesame period, the occurrence of large negativereturns has been very low at just 0.4% of allcases (figure 10). Additionally, European loansdelivered annual returns above 4% in 61% of allcalendar years.2.4 Historical volatilityThe solid profile of SSLs is also reflected in theirvolatility as measured by the Credit Suisse LeveragedLoan Index for US loans and the Credit SuisseWestern European Leveraged Loan Index. Since thelaunch of the loan indices mentioned before, theindices annual volatility has averaged between 2%and 3% with the exception of the subprime crisisyears i.e. the period of October 2008 to March2010. In addition to the consistently low ‘absolute’volatility (with an exception of the subprime crisisyears mentioned before), the low ‘relative’ volatility(except the period July 2007 to February 2011)compared to selected European and US bondindices (investment grade) has also been veryimpressive (figure 11). This phenomenon can beexplained by the regular adjustment of SSL floatingrates to current market rates. Assuming unchangedmarket liquidity and creditworthiness, the impactTable 7SSL performance in diverse market phasesThesis: SSL work in most interest rates scenariosEurope businessCha

Oct 20, 2017 · 29 years (between 1987-2015), the average debt recovery rate measured by ultimate recoveries for US SSLs was 80.4%, while for US High Yield bonds it 1was 48.8% on average . Additionally, SSLs are floating rate instruments, while High Yield bonds are issued with a fixed