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Chart tracks the performance of loans in times of rising interest rates, whereas traditional government bond funds, ETF, and pools decline.Let me be blunt: interest rates will likely not stay this low forever. It’s just a matter of when they rise. And that’s exactly the time you want to be positioned in senior loans.
Chart tracks the performance of loans in times of rising interest rates, whereas traditional government bond funds, ETF, and pools decline.Let me be blunt: interest rates will likely not stay this low forever. It’s just a matter of when they rise. And that’s exactly the time you want to be positioned in senior loans.

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Floating-rate secured loans not just for the wealthy Add to ...

Equity investors have had to endure significant volatility since 2008. Traditional bond investors, on the other hand, have generally had a very good run, as interest rates have dropped to all-time lows this last quarter, therefore pushing bond prices steadily upwards.

But pity the poor income investor today. While many have seen capital gains as their bonds have risen in price, current yields have fallen through the floor. The continuing low-interest rate environment has made it very difficult to secure income from traditional income assets such as government bonds.

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This change means investors need to rethink their approach to income. Instead of building a “set it and forget it” portfolio of government bonds, income investors need to look at multiple alternative income streams, without necessarily abandoning bonds altogether.

One of the streams worth taking a closer look at is floating-rate senior secured loans (“senior loans” for short). They’re an asset class that has flown under the radar among the general population, but they’ve recently become quite popular with high-net-worth (HNW) investors.

There are a number of good-quality funds and low-cost ETFs that offer exposure to this space (either via U.S. dollars or hedged back to the loonie). With that in mind, here’s a quick run-down on this asset class.

What are floating-rate senior secured loans?

“Floating-rate senior secured loans” sound complicated, but most of the time they aren’t. They are simply asset-backed loans issued by companies with below-investment grade credit ratings. They are “floating-rate” because the interest owed “floats” up and down with broader-market interest rates. They are “senior” because they usually take priority over other loans in the case of default. And they are “secured” because unlike many other forms of lending, they are backed by hard assets (factory equipment, real estate, etc.).

Performance of this asset class has been picking up so far this year

As of August 31 st , 2012, the Credit Suisse Leveraged Loan Index has risen about 3.4 per cent YTD. By comparison, the DEX Bond Universe return is up about 2.6 per cent.

But when interest rates rise, that’s when this asset class really begins to shine. The chart above tracks the performance of loans in times of rising interest rates, whereas traditional government bond funds, ETF, and pools decline.

Let me be blunt: interest rates will likely not stay this low forever. It’s just a matter of when they rise. And that’s exactly the time you want to be positioned in senior loans.

Protection from credit risk

Senior loans are usually originated from companies with below investment-grade credit ratings. So from one perspective, senior loans are “riskier” than government bonds and investment-grade corporate bonds.

However, senior loans come with protection that many other types of loans (including bonds) don’t. If a company runs into trouble, senior loans will typically be paid before bond holders, preferred shares, or common stock (hence “senior”).

In addition, if a company defaults, investors in senior loans will usually get more money back than other creditors. In fact, a study from ING Investment Management found that between 1995 and 2011, the recovery rate for first-lien loans averaged about 71 per cent. Compare that to high-yield bond investors, who typically got 44 per cent of their money back.

After the 2008 credit crisis, the default rate for senior loans peaked in 2009 at about 10 per cent. I think it’s reasonable to consider that a worst-case scenario. Corporate balance sheets are stronger than they were back then, as many companies have been paying down debt and hoarding cash. Currently, the default rate for senior loans is about 0.2 per cent. No, that’s not zero, but it compares favourably to high-yield bonds, whose default rate is about 2.5 per cent.

Good hedge against interest rates / inflation resurfacing at some point

Unlike traditional bonds, the interest rate on senior loans is reset regularly (generally quarterly). This is usually expressed as a “reference” interest rate (generally LIBOR – London Interbank Offered Rate) plus a spread. So as the reference rate moves, the interest you receive will fluctuate.

This can be very attractive in times of rising interest rates. When rates rise, the prices of government bonds typically fall. This can play havoc with bond portfolios: your income remains the same, but the value of your bonds can go down dramatically. But this isn’t an issue with senior loans. Because the reset date is usually only three months away, you don’t really have to worry about interest rates.

Lower correlation

Correlation is a measure of how often one asset class moves in the same direction (either positive or negative) as another. So, if you have two assets with a correlation of 1.0, it means the two assets move in lock-step with each other. A correlation of –1.0 means they move in equal but opposite directions.

Senior loans have a pretty low correlation with other assets. Since 2009, the S&P/LSTA Leveraged Loan Index has had a correlation of 0.59 with the S&P 500. Compare that to the Bank of America/Merrill Lynch U.S. High-Yield Master II Index, which had a correlation of 0.73.

So if you’re looking for diversification (and you should be), senior loans may fit the bill. This is particularly true if you’re looking to offset a stock portfolio.

I want to be very clear here: senior floating-rate loans are not a full replacement for traditional bonds. Better to consider them a complement to the more traditional portion of your income portfolio, and a hedge against potential interest rate increases.

But they’re an asset class that’s definitely worth exploring, and one that’s under-represented in most investors’ portfolios. I would target an allocation of perhaps 10-15 per cent of a total fixed income portfolio, and consider them an excellent alternative to high-yield bonds.

Thane Stenner is founder of Stenner Investment Partners within Richardson GMP Ltd., as well as portfolio manager and director, wealth management. Thane is also Managing Director forTIGER 21 Canada. He is the bestselling author of ´True Wealth: an expert guide for high-net-worth individuals (and their advisors)’.www.stennerinvestmentpartners.com(Thane.Stenner@RichardsonGMP.com). The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Ltd. or its affiliates. Richardson GMP Limited, Member Canadian Investor Protection Fund.

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