Senior Loans: ‘Hunkering Down’ At The Top Of The Capital Structure

ETFS

I will confess right up front that I have no idea which way the economy or the markets are going to go in the next few months or in 2021. Obviously there are a lot of optimists who believe that a combination of aggressive actions by the Fed, a resilient corporate America committed to muddling through no matter what, and the expectation of relatively fast progress in treating, containing and ultimately preventing the spread of the coronavirus will allow the economy and our financial markets to continue their generally upward movement without another major reversal.

But there are many others who are more pessimistic. They see a yawning gap between Wall Street’s expectations and the reality on the ground on Main Street for many Americans. With the pandemic picking up speed in many parts of the country, no coordinated national policy for dealing with it, many political leaders apparently in denial about it, and the potential risk of a constitutional crisis in the fall if we end up with a contested election result, the pessimistic case seems every bit as plausible as the optimistic one.

I don’t claim to know which view is correct. Nor do I feel confident betting my own retirement savings on either view. What I want, until we have a clearer view of what lies ahead – medically, economically, and politically – are what I call “hunker down” investments that will pay us reasonable and relatively reliable income while we wait for the clouds currently obscuring our view to dissipate a bit. I say “relatively” reliable income because, in the current environment, nothing is a certainty. So unless you can afford to go into cash or government bonds that pay almost nothing, you have to be prepared to take SOME risks if you want to retain some level of portfolio income. So we are seeking manageable risks that can be analyzed, modeled, and mitigated to at least some degree.

Enter Senior Corporate Loans

Senior corporate loans are an asset class that I would put at or near the top of my short list of candidates for our “hunker down” portfolio. Their position as the most senior liability in the capital structure makes them an attractive asset class for conservative portfolios that hold them directly for their “naked” cash yield (5-6%), or for investors like me who want to boost our returns a bit by holding them in a closed-end fund that can be bought at a discount and leveraged with cheap institutional borrowings.

Although the chart below may state the obvious to many readers, it is worth emphasizing, especially since some investors have what seems like a knee-jerk reaction to so-called “junk” (i.e. non-investment-grade) securities, when they are in the form of debt. But many of those same investors seem to have no particular objection to holding riskier, non-debt securities (i.e. stock) issued by the same cohort of companies.

Corporate Liability Structure
Liability Type Description/Characteristics
Senior Loans (aka Corporate Bank Loans, Leveraged Loans) Loans syndicated (underwritten) by banks to non-investment-grade corporations; secured by all or most or the key corporate assets; first in line for payment in bankruptcy or liquidation
High Yield Bonds (aka “Junk Bonds,” Speculative Grade Bonds) Bonds underwritten by banks to non-investment-grade corporations; unsecured general creditors of the corporation; get paid “pari passu” (in same proportion) as other unsecured creditors in bankruptcy or liquidation
Convertible Bonds Bonds that can (or sometimes must) convert into equity under certain conditions. Usually issued by non-investment-grade companies. Convertible bonds and preferred stock are both considered “hybrid securities.”
Preferred Stock Equity with bond-like qualities. Receives dividends rather than interest, but its dividends have priority of payment over common stock dividends; also gets paid ahead of common stock in the event of bankruptcy or dissolution. May have other unique features like convertibility into common stock.
Common Stock

Owns the residual claim to all the earnings and assets of the company, after all the obligations above it in the capital structure are satisfied.

Some basic observations about senior loans and their relative risk/reward characteristics versus other asset classes:

  • The cohort of companies issuing these loans: “non-investment grade” companies (i.e. companies rated BB+ and below). Non-investment grade companies are the majority of all companies. Over 50% of outstanding corporate public debt is non-investment grade, and 75% of newly issued corporate debt in recent years has been non-investment grade. Although it varies all the time as companies’ credit ratings are upgraded and downgraded, somewhere between 10% and 15% of the S&P 500 is made up of non-investment-grade companies. So even if you limit your investments to the S&P 500, you may have over 10% of it in so-called “junk” companies.
  • But many investors don’t limit themselves to just the S&P 500; they also invest in mid-cap and small-cap funds or individual mid-cap and small-cap stocks. Mid-caps and small-caps are virtually ALL non-investment grade.
  • Bottom line: If you invest in mid-cap or small-cap equities, you are investing in so-called “junk,” whether you realize it or not.
  • But your risk, as an equity investor, is much greater than if you were investing in the company’s “junk bonds” further up the balance sheet since bondholders have to be repaid 100% before equity owners are entitled to anything.
  • The story gets even better for senior loan investors since senior loans are secured by the company’s assets, and they have to get repaid in full before the bondholders (who are unsecured) get paid. (Both groups, of course, have to get repaid before the stockholders are entitled to any payments).
  • The upshot is that “junk bonds” and senior loans (together referred to as “high yield debt”) both carry far less risk than equity owners in the same cohort of companies.
  • Despite this, if you asked many small-cap and mid-cap equity investors if they would consider investing in high-yield debt, the answer many would give is: “No, it’s too risky.” That’s because they have latched onto the name “junk” without really appreciating (1) what it does – and doesn’t – mean, and (2) who the cohort of companies to which the label has been attached actually are. As a result, they fail to realize that a portion of the stock portfolio they already own is much riskier than the high-yield “junk” debt (bonds and loans) that they swear they would never buy.

Quantifying the risks of senior loans

Individual non-investment-grade companies can be very unpredictable, but in diversified pools (i.e. funds, indices, etc.), they are pretty easy to model and we have decades of experience and statistical data through all sorts of economic ups and downs to rely on in evaluating future behavior and risks.

Overall, non-investment-grade credits have defaulted at an average annual rate of 3-4% over a long period of time (actual defaults have been far less than that in recent years). Over the past 30 years, the one-year default rate has never exceeded about 13%, which also happens to be the “pessimistic case” projection by Standard & Poor’s analysts of what the corporate default rate could reach during the current economic crisis.

What would a 13% default rate mean for a portfolio of senior loans? The average recovery rate for secured loans (senior loans are all secured) has been about 75-80% for many decades. If we assume 75% recoveries, that means the loss on those loans, after recovery, will be 25%. So if we assume 13% were to default, and we averaged a loss of 25% on each one, then our portfolio loss would be 25% X 13%, or 3.25%. That would probably wipe out less than half of one year’s cash distributions on a diversified portfolio of loans (or loan funds).

S&P’s more modest “baseline case” scenario projects a default rate of 10%, which happens to be what the default rate jumped to in the 2008/2009 recession. With 10% defaults and 25% losses on the defaulted loans, the portfolio loss rate would be 25% X 10%, or 2.5%. (In a typical year, where average defaults were 3% or 4%, the losses on a loan portfolio would be 25% of that 3% or 4%, which would be 1% or less).

This obviously showcases the advantage of being secured versus being unsecured, as high-yield bonds are. Unsecured bonds, over many years, have recovered about 50% versus 75-80% for secured loans. That means HY bonds have a loss rate of 50% versus 25% for loans. Since the cohort of non-investment-grade companies that issue secured loans and HY bonds is essentially the same, the default rate is therefore the same as well. (In other words, when a company defaults on one type of debt, like its bonds, it also defaults on its other debt, including its loans, which have “cross default clauses” that trigger when some other debt defaults).

So if 13% of the companies default, and you hold their bonds that lose 50% instead of their secured loans that only lose 25%, your overall portfolio loss will be 13% X 50%, or 6.5%, twice the loss of the secured loan investor. If the more modest baseline case prevails, and the default rate is “only” 10%, then unsecured bondholders will lose 10% X 50%, or 5% of their portfolio, again twice the loss of secured loan investors. (In a typical year, of course, with defaults only 3% or 4%, HY bonds would have a portfolio loss of about 50% of 3% to 4%, which would be between 1% and 2%, half of the losses on a senior loan portfolio).

In both cases – whether you are a secured loan investor or an unsecured bondholder – you are better off than the equity investors down below you, who will likely lose all or most of their entire investment in a company that goes bankrupt or liquidates. (We say “all or most” because sometimes, in complex bankruptcies, senior creditors ahead of other creditors or stockholders will agree to let those below them in the capital structure get something – “crumbs from the table” – even though they are not theoretically or legally entitled to it, just to get them to go along and avoid lengthy litigation).

Quantifying the returns of senior loans

Within the senior loan category, not all loans are the same in terms of their risk/reward profile. Single-B rated companies default at more than twice the rate of double-B-rated companies, and triple-C-rated companies default at over twice the rate of single-B companies. That’s why the yield the market requires issuers to pay varies widely up and down the spectrum of credit risk, even within the non-investment-grade category.

Currently, an investor could anticipate yields of approximately the following, for various levels of credit rating:

Leveraged Loan Yields
Segment of the Market Current Yield
100 Largest, Most Liquid Loans 6.3%
Total Market Average 7.0%
BB-rated Loans 4.5%
B-rated Loans 6.6%
CCC-rated Loans 17%
Source: The Author and Industry Sources

Assume a typical portfolio of senior loans would include an assortment of BB and B rated credits, with a few CCC rated loans as well, resulting in a blended yield similar to the average shown above, of about 7%. Owning them in a closed-end fund means the investor can probably buy the fund shares at a discount of 10% or more, which means the yield on the 90 cents on the dollar you actually invested is really 7.8%. But then the fund can go out and leverage itself at cheap institutional leverage at perhaps 1% or 2% in the current environment. If it borrows an amount equal to 33% of its net assets (typical for many closed end funds) at 2%, that means it earns an additional spread of, say, 7% minus 2%, or 5% on 1/3rd of its shareholders’ funds, which adds 1/3 of 5%, or 1.7%, to each fund share’s earnings. Add that 1.7% to the 7.8% yield (after discount) brings cash flow per share up to 9.5%.

That’s the closed-end fund “alchemy” of discounts plus cheap leverage that allows them to pay a cash yield higher than the “naked yield” of their portfolios that you would typically earn in an un-leveraged open-end mutual fund or ETF. Funds from the list below that pay even higher yields than that are able to do it by investing in lower credit-rated, higher-yield portfolios, where the naked yield is higher to begin with, and the leverage adds more spread as well.

Lower credit-rated loans can sometimes be less risky than the ratings on the issuer suggest, depending on how well structured and secured the loan is. When I worked at S&P about 20 years ago, we introduced “recovery ratings” for the first time, which provided a second dimension to the corporate rating process that previously only considered the risk of default. From that point forward, S&P has done two analyses as part of rating a corporate credit: one that analyzed the risk of default, and a second one that analyzed the value of the collateral and the likelihood of being repaid in the event of default. As a result, a low-rated, default-prone borrower might end up with a well-secured loan that got a relatively higher rating because of the strength of its collateral. This has made the loan market more complex and has allowed bankers and investors to structure loans to low-rated borrowers that command very high interest rate spreads, but which are well secured and less risky than loans to higher-rated borrowers that have weaker collateral packages. (Read this article for the interesting back-story about how that all came about).

Senior Loan Funds

Readers will see from the above yield spreads that within the senior loan category, there is a wide range of potential risk and reward, depending on what part of the market an investor wishes to participate in. That is a big reason why when we look at the list of closed-end funds in the Senior Loan category, we see such a wide dispersion of distribution rates. (I eliminated CLO funds, which buy leveraged pools of loans and have a whole different risk/reward profile, along with other funds that were not typical loan funds. CLOs are an attractive asset class and may have a place in some of our portfolios, but are not part of this discussion).

In reviewing this list of senior loan funds from CEF Connect, I examined particularly the following data points: (1) distribution yield, (2) price discount, (3) recent dividend changes, (4) the percentage of riskier assets (i.e. single-B and below) in the portfolio, and (5) earnings coverage of the distribution. Then I marked in yellow wherever a particular fund appeared to be strong in one or another of those categories. So as you read across each fund’s data, the more boxes highlighted in yellow, the stronger that fund would appear to be as a potential investment candidate.

I started with distribution yield, where some of the loan funds are offering unusually attractive yields, while some of the more conservative ones are paying down in the 4% to 7% range. I highlighted those paying 9% and above, although 8% is still an attractive return for this asset class, especially, as we will see, for some of the funds with less risky portfolios. One of the highest-yielding funds Nuveen Credit Strategies (NYSE:JQC) is a special case where it has adopted a policy to pay out a higher-than-sustainable distribution in order to reduce its discount and give capital back to shareholders. The other unusually high distribution is that of Aberdeen Income Credit Strategies (NYSE:ACP). ACP is a more internationally based fund which has, so far, not adjusted its dividend down to reflect any pandemic-related impact to its cash flow. The fund’s web site doesn’t give any indication of its distribution plans, but I note that its dividend coverage ratio (which we’ll discuss generally later on) is nowhere close to 100%, so the market may have already assumed a cut is coming at some point. Note there isn’t the price discount cushion for ACP that there is for some of our other fund candidates, either, leading me to think there are more attractive candidates, as we shall see.

When we look at the “Discount” column we see that numerous loan funds offer big – higher than normal – price discounts, which provides an extra cushion against defaults or other cash flow interruptions. I highlighted all the funds – 16 of them – that have discounts of 13% or higher.

Several funds already jump out at me, with their big distributions and high price discounts. In particular: Invesco Dynamic Credit (NYSE:VTA) with its 10.2% distribution yield and a whopping 16.4% discount; Ares Dynamic Credit Allocation (NYSE:ARDC) with a 9.7% yield and 16.3% discount; Invesco Senior Income (NYSE:VVR), yielding 8.25% and a 15.9% discount; and BlackRock Floating Rate Strategies (NYSE:FRA), with an 8.32% yield and a 15.4% discount. Beyond that, there are a whole slew of other funds with attractive yields and only slightly lower discounts (in the 14% range, which in normal times would be way above the norm), as well as funds – like Apollo Senior Floating Rate (NYSE:AFT) and several Eaton Vance funds (NYSE:EFR), (NYSE:EFT), (NYSE:EVF) – whose yields are nothing to write home about, but which offer very attractive discount pricing.

When you move over to the “Dividends” column, where I tried to capture what the recent dividend movements were, things get even more interesting. Quite a number of funds show “steady” which means they have not dropped their dividend rates, at least not yet. I find “steady” to be more impressive when it is combined with a high dividend coverage percentage (the far right column) than if it is not. I already noted ACP’s high distribution rate and low coverage ratio, which make its up-until-now steady dividend a bit suspect. On the other hand, the two Invesco funds, VTA and VVR, each have “steady” dividends and coverage ratios close to (96%) or above 100%, which makes me believe it is more likely they may be able to hold their existing dividend rate (or if they have to drop it, keep the reduction modest).

Funds that have already dropped their payouts, but now show full dividend coverage of their new, reduced distribution levels, are worth noting. If we are considering them for purchase now, our main focus is not so much on what happened previously, but whether their current price, dividend yield and coverage ratios are appropriate going forward. And if we can buy them at a nice discount, then that adds even a bit more comfort. From that perspective, the three Blackstone funds – (BGX), (BGB) and (BSL) (which I highlighted in blue) are worth considering. They all experienced modest dividend cuts, but their current distribution yields (9.7% for the first two, and 8.7% for BSL), combined with 12% discounts, look attractive. They also play in a rougher neighborhood, in terms of credit risk, as seen in the next column showing what percentage of their portfolio is in lower rated (single-B and below) credits. The same goes for Ares (ARDC), which I also marked in blue although it is not as concentrated in lower-rated credits as the Blackstone funds and it has a huge 16% discount.

Similarly, the Nuveen funds – (JSD), (NSL), (JFR), (JRO), JQC – all took big dividend cuts early on in the crisis, which may indicate their management wanted to get the pain over with quickly. Now they all have healthier coverage ratios (except for JQC noted above) and may be good choices for more conservative investors willing to accept yields in the 7% range in return for a less risky portfolio. To see why they are less risky, see the 5th column over, “Portfolio % B and below.” The Nuveen funds, with not much more than half of their portfolio invested in the riskier (single-B and below) credits, should have lower default rates and loss rates than those like the Blackstone funds or Apollo that have over 90% of their assets in the lower-rated and more default-prone rating categories. (Blackstone would undoubtedly argue – perhaps correctly – that they are such experienced credit analysts and portfolio managers that they can select and manage lower-rated credits successfully, etc. There are a number of boutique credit shops that have developed that expertise over the years, but it is very hard as an outside investor to judge those sorts of qualitative factors. That’s why I diversify, diversify, diversify…).

Looking for the “Sweet Spot”

Ideally we would want to find funds that meet all these criteria:

  • High distribution yield
  • Big price discount
  • 100% dividend coverage
  • Lower percentage of high-risk credits

Some that meet most of them, and are on my “short list,” are: VTA, VVR, FCT, BGX, BGB, BSL, ARDC, TSLF, FRA, NSL, JFR, JSD, EFR.

The mere fact that some of them have a higher proportion of single-B and below credits does not, in itself, rule them out as long as they are covering their distribution and/or there is an above-average discount to help offset the greater risk. Apollo is an interesting case. Its distribution is relatively small (6.4%) and yet its discount is substantial (almost 17%). In addition, the Apollo Group has a good reputation in the leveraged credit field (like Blackstone above), so it may be a reasonable investment, at a modest level. The other lower-yielding choices, mostly Eaton Vance funds, plus PPR (the original loan fund) are truly conservative, lower risk funds for those who want a more rock-solid albeit lower-yielding cash return.

Bottom line, for me: I plan to build a position in the senior loan asset class as part of my “hunker down” portfolio, the one I expect to hold up and provide an income stream regardless of whichever of the optimistic or pessimistic scenarios outlined at the beginning of this article turns out to be accurate, and will probably spread my investment around among the “short list” mentioned above, especially the Invesco, Blackstone and BlackRock funds.

One more thing…

Many readers have encouraged me to launch a Marketplace service to supplement my free articles and provide a more frequent and detailed look at Income Factory portfolios and the research process that supports them. Starting soon I plan to launch “Inside the Income Factory,” a boutique service that will provide member/subscribers real-time access to all trades and “tweaks” to our 4 Income Factory model portfolios, plus interactive discussions about portfolio candidates and other topics readers suggest. I welcome suggestions about topics, format, presentation and whatever would make it most attractive and useful to our Income Factory community.

Disclosure: I am/we are long FCT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I will probably initiate positions in the “short list” candidates mentioned in the article over the next few weeks.

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