Today’s investors face few options for generating income in a rising interest rate environment. Lofty stock valuations and heightened market volatility would normally prompt investors to seek the relative safety of fixed-income securities as a way to generate income and preserve capital. However, that strategy faces obstacles. Senior secured loans offer a potentially compelling solution.
What are senior secured loans?
Senior secured loans are debt obligations generally issued by non-investment grade businesses. These loans are usually “secured” by a company’s assets, and are typically used to fund a company’s growth or cover general operating expenses. The borrower is the company itself, not a bank.
What makes these loans different? Senior secured loans can diversify an investor’s income strategy, help preserve capital, and serve as a hedge against rising interest rates. Because of these attributes, the senior loan market has grown over 250 percent in the last decade, today exceeding $915 billion.1,2 With that growth has come a greater breadth of investor into the sector.
Loans can range from $50 million, considered small by market standards, to greater than $10 billion, issued by some of the country’s largest businesses. Since the late 1980s, banks and other financial institutions have sold portions of these loans to institutional investors as part of a syndication process.
The regulations stemming from the 2008 global financial crisis spurred changes in the senior secured loanmarket. These restrictions have limited borrowing opportunities for many small and medium-sized American businesses—the cornerstone of our economy—from traditional bank channels. These businesses have turned to alternative sources of financing, such as Business Development Companies (BDCs) and private lenders, creating new opportunities for investors to access the loan asset class.
Focusing on income in an income-starved environment
Investors are facing a challenging investment backdrop, particularly when looking to generate income. With the stock market approaching all-time highs, leaving little room for incremental upside, many investors are hesitant to increase their equity exposure.
After years of quantitative easing by central banks, which have utilized near-basement level rates to stimulate economic growth, the bond market faces its own set of difficulties.
Senior secured loans have produced consistent income through varying interest rate environments, averaging a 5.39 percent income return since 2002 (Figure 1). This consistency also brings a measure of downside protection should interest rates change.
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