Interest rates are rising with no end in sight. As many investment portfolios were strongly geared towards negative rates in the past, they should now be reviewed. In the fixed income sector, senior secured loans are currently attractive. These loans benefit from rising interest rates but are not a risk-free licence to print money.
Senior secured loans (SSL) differ from corporate bonds in a number of key respects. First, they are not bonds, but loans from banks or other institutional lenders to companies. As a result, there is no raising of capital on the bond market. Secondly, there is a different rate of interest on these loans: the rates are not fixed but are geared to the current interest environment via a variable component. Thirdly, SSL enjoys the highest seniority in the debtors’ capital structure thanks to various credit protection mechanisms. In senior secured loans, investors are served first in the event of a payment default.
Rising interest rates are both a blessing and a curse
The current rise in interest rates has a negative impact on the value of fixed-interest bonds. On the other hand, they have a fundamentally positive effect on senior secured loans. They increase the interest earned for investors, as SSL with variable interest rates pay a higher return. But again there is another side: as interest rates rise, the interest burden for debtors grows, which puts an additional financial burden on these companies.
As a high-yield product, SSL is predominantly located below the investment grade rating segment. Hence, they are most likely to be compared to riskier high yield bonds. Swiss Life Asset Managers particularly selects companies from the highest possible non-investment grade segment, the so-called upper tier, with better credit quality.
Select creditworthy companies for senior secured loans
In order to minimise the risk of default, borrowers should be carefully selected. Many so-called zombie companies were able to survive in the low interest rate environment, which lasted for years. In the rising interest rate environment, they need to be filtered out as they may get into trouble with the increased exposure. The major rating agencies therefore already expect default rates to rise compared to previous years. Moreover, in the US, which accounts for around 80% of the SSL market, many companies were rescued with state aid during the coronavirus pandemic from possibly falling victim to the recession. Last but not least, the credit terms, the covenants, must also be critically examined. They specify, for example, which debt or interest burden debtors may not exceed.
In recent years, the search for and increased demand for covenant-lite loans with yield and investment opportunities in a low interest rate environment has become fashionable. In these cases, credit conditions were gradually softened. According to S&P Global Market Intelligence, this affects more than 90% of the SSL issued in 2021 in the US market, which is still worth a good USD 1.3 trillion. By way of comparison: in 2000, covenant-lite loans accounted for only 1% of the market.
An adequate evaluation of SSL requires an understanding of market risks, credit risks and credit conditions. This is the only way to add value for investors. From a Swiss Life Asset Managers’ perspective, the added value is also to be forward-looking and self-determined and not engage in every new transaction popular with the market, which may fall victim to the next economic downturn. This more defensive investment strategy of Swiss Life Asset Managers also proved its worth in the year of the coronavirus pandemic outbreak.
Find out more here about the Fixed Income asset class of Swiss Life Asset Managers.
