What Are Senior Loans?

Senior loans are known as a number of things, the most well-known being syndicated bank loans and leveraged loans. Basically, these are loans provided to corporations by banks, and then sold to market investors. Senior loans reached their peak in popularity in 2013, performing well beyond what was considered a dying market at the time, and raking in billions because of it. If you are an investor or trader, knowing about senior loans is an essential part of trading 101. So here are some facts concerning the world of senior loans.

1. Collateral

Senior loans are basically the basis upon which a company stands, they hold the most essential part of its capital. This means that upon failing, those investing in the senior loans of a given company would be compensated before any other investors. Although senior loans may procure just as much profit as high-return bonds, they offer a much smaller risk.

2. Risks

Despite the fact that senior loans may not be as risky as bonds, for example, they do hold risk to some extent. Of course, every investment holds a certain degree of risk. When seen alongside other loans, senior loans hold a much higher degree of credit risk. In order to get a good idea of just how risky senior loans are, it would be of benefit to put this risk into perspective. Despite the fact senior loans are not as risky as, say, high-yield bonds, they are much riskier than investment-grade corporate bonds.

However, this market is constantly developing and changing, and this is essential to take into account. Risks will not always be as high as they appear today, and will not always compare to other investments the same way they do now. Senior loans also involve drastic changes, just as any other investment. August 2011, for example, saw PowerShares Senior Loan Portfolio dropping 7.7% in a matter of days. Senior loans also dropped substantially in 2008 due to the financial crisis.

3. Returns

When these loans do happen to procure some sort of return, however, they tend to be relatively high. This especially accounts for securities rather than the common investment-grade corporate bonds. However, in the case of bankruptcy, the fact that those investing in loans are repaid before those that have chosen to invest in bonds means that loan investors will benefit from lower yields than they would have from a high-yield bond.

4. Rates

Senior loans, similar to most bank loans found on the market, offer something that is called a floating rate. These rates are accommodated to a higher amount according to reference rate. Reference rates commonly used are the London Interbank Offered Rate (LIBOR).

In other words, the rate a senior loan would be likely to use is LIBOR plus the chosen percentage of the loan. This can be anywhere from 1% to 5%. Therefore, if senior loans are to adopt a rate of LIBOR + 3% at a time wherein LIBOR has reached a reference rate of 2%, the combined rate that a senior loan will adjust to totals to 5%.

5. Diversification

As with any asset, it is possible to form an investment portfolio using senior loans. The best part about using senior loans within your investment portfolio is the fact that they are unlike any other assets on the market. They do not correspond or interact with very many other assets, and when they do so it is to a very minimal degree. For this reason, adding senior loans to your portfolio will help further diversify your earnings.