While it is our belief that senior loans should be viewed as a core holding in a fixed income portfolio over the long term, and that tactically “timing” a complete entry/exit to and from the asset class can oftentimes backfire on investors, there are times when senior loans represent an incrementally attractive opportunity for investors. We believe now is one of those times.

The Evergreen Case

The long-term case for senior loans is evergreen. Over the past 27 years, the senior loan market has generated positive total returns in 26 of them. Over this timespan, there were different interest rate environments and full credit cycles, and yet senior loans held up quite well throughout most of these diverse conditions. The most recent case in point: year-to-date the loan market has generated a positive total return of 5.61% despite a drop of 22 basis points (bps) in the U.S. Treasury 10-year yield. This is a result of senior loans’ unique characteristics of historically generating relatively high income, typically having very low interest rate sensitivity, ranking senior in priority in an issuer’s capital structure, and being secured by the assets of the issuer. The primary risk with senior loans is purely credit risk, and because defaults have historically been very low (with the long-term average less than 3%), the attractive attributes of the asset class generally enable it to navigate successfully in most market environments.

However, unlike bonds, senior loans have no call protection. They are callable at par at any time. As a result, their normal trading range is 98-100, and never much above that. Hence, 99% of their total return over the long term comes from their high coupon. It is uncommon to expect and receive additional return from any price appreciation unless the loans are available at a discount.

The Relative Value Opportunity Now

Currently the average price of the senior loan market remains suppressed at about 96.5, below the average range of 98-100. Only 16% of the senior loans in the asset class’ major index are currently trading at or near 100. That low level compares to over 80% a year ago. Exhibit 1

As illustrated in Exhibit 2, the average historical spread between senior loans and high-yield bonds is 110 bps. However, today the credit spread of the senior loan market is now greater than that of the high yield market by about 20 bps to 30 bps. That means the spread right now between senior loans and high yield is inverted. Investors are getting paid less for being in a lower credit quality asset class.

Let’s explore why that is and discuss what we view as the subsequent opportunity.

Follow the Money – the Answer Can Be Found in the Flows

The opposite direction of retail flows between senior loans and high-yield bonds tells the story. Exhibit 3 The senior loan market has had $13 billion in retail outflows year-to-date, while the high-yield market has taken in $15 billion of retail inflows. Greater investor demand for high yield has caused credit spreads in the market to tighten, while lower demand for senior loans has had the opposite effect.

Since the beginning of this year, the U.S. Federal Reserve has reversed its posture from a tightening stance, which it had as recently as the fourth quarter of 2018, to now signaling one or more potential interest rate cuts this year. A meaningful portion of the retail investor base views the senior loan asset class as simply a tactical interest rate play, to be purchased only in a rising interest rate environment. In our opinion, the flaw in that limited view is the dismissal of the importance and value of the other attractive attributes that loans have the potential to deliver high income and senior secured positioning in the capital structure. That distinct combination historically has produced a favorable risk-adjusted return profile relative to many other major asset classes. Exhibit 4

Senior Loans Are Pure Credit Risk

We spent much of this piece describing the opportunity today from the dislocation in senior loan valuations because of a technical imbalance. We find valuations of senior loans to be attractive today, and certainly in comparison to other lower quality asset classes such as high-yield bonds. However, at the end of the day what matters most to professional senior loan investors is the associated credit risk of a given loan. Will an issuer be able to support its debt, pay its coupons, and pay off the loan at maturity? Bottom-up fundamental credit analysis is critical in determining the risks, the downside, the asset coverage, and the return of each individual loan. It is a deep and thorough analysis that considers a whole host of factors, including the value of the assets securing the loans, covenants, cash flows, credit statistics (such as total leverage, interest coverage, and defaults) and management teams, among many other considerations.    

Credit Quality Snapshot Today

We would characterize the overall credit quality of the senior loan market now as generally solid. Full U.S. employment, modest gross domestic product (GDP) growth, positive corporate earnings with top- and bottom-line growth, decreasing leverage, and below average default rates all support this benign outlook.

In Summary

While we try to discourage investors from tactically timing the senior loan market simply on the basis of interest rate direction, we do see an unusually attractive opportunity today in which investors can seek to take advantage of a temporary technical dislocation between senior loans and high-yield bonds by moving up in credit quality without giving up the potential for yield. We expect this relative value dislocation will eventually correct once rates stabilize, and as lighter new issue supply finds balance with the current level of demand.

In the meantime, we believe there is a compelling case to be made that, in addition to the evergreen case for loans, investors can now move up in credit quality from junior to senior priority and from unsecured to secured status without giving up yield. Senior loans are currently yielding close to 6% and there is the potential for another few points of additional return from price appreciation. In our view, combining that with solid credit fundamentals makes a strong case for the merits of revisiting senior loans.