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Scott BaskindInvesco Senior Secured Management Inc.

A look at the services and products that are remaking the world of insurance asset management.

BEST’S REVIEW • JUNE 2019

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BEST’S REVIEW • JUNE 2019

Senior Secured Loans: Looking Beyond Interest Rates

follow rising rate expectations. If the economy underperforms expectations, loans’ defensive positioning within issuers’ capital structures should help stabilize the asset class relative to other credit products, as occurred during a volatile 2018. In either scenario, loan yields continue to best those of high yield bonds, despite the security of being at the top of the capital structure.2

How can loans’ senior and secured status benefit investors at this stage of the cycle?Loans’ senior and secured status provides investors with a unique credit risk mitigation mechanism that has contributed to the asset class’s low historical rate of volatility. As the senior ranking debt in the capital structure and secured by the collateral of the company’s assets, interest and principal payments to loans take priority over most other forms of debt and equity. If a company faces financial hardship, loans have a priority claim on the company’s assets and are to be repaid first. During instances of default, this translates to senior secured loans recovering 80% of principal on average over the last 30 years (compared to 48% for unsecured high yield bonds).3 Furthermore, BB and B rated loans (which constitute a vast majority of the index) have exhibited a relatively stable total return profile during periods of elevated defaults.

Scott Baskind, Head of Global Senior Loans and Chief Investment Officer believes that senior secured loans’ high level of current income, defensive positioning at the top of the capital structure, and low correlation to traditional asset classes can support the argument for loans to be a strategic allocation in investors’ portfolios.

How have stagnant or decreasing interest rates impacted loan returns? Historically, senior secured loans’ overall coupon, not net increases in reference rates, have been the primary driver of returns and have contributed to the overall stability of the asset class. This is because the components of loans’ coupon (LIBOR and a credit spread) typically display an inverse relationship. As LIBOR increases, usually driven by macroeconomic strength, strong demand for floating rate loans enables issuers to reprice or refinance their loans—resulting in a decline of the credit spread. Conversely, when LIBOR declines, usually amid macroeconomic weakness, credit spreads have increased to compensate investors for the increase default or credit risk. Given this dynamic, dating back to 1992, loans have only produced two years of negative total returns (2008 and 2015) as the asset class’s relatively consistent and high level of coupon has more than compensated for price declines.1

How do loans currently compare to traditional high yield bonds on a relative value basis?On a relative value basis, we currently believe that loans present an attractive opportunity compared to unsecured high yield bonds. With the Fed’s hiking cycle on pause, investors have rotated capital from floating rate loans to fixed rate bonds. This myopic focus on interest rate expectations has led to investors trading senior secured risk for unsecured risk, despite loans’ yield being comparable or even exceeding that of unsecured high yield bonds.2 While investors have been rewarded through April for this shift in asset allocation, we now believe an opportunity exists to reverse this tactical allocation.

In today’s economic environment, senior secured loans can offer investors who are concerned about the length of the current U.S. economic growth cycle a compelling high return/lower volatility opportunity. If the economy outperforms expectations in 2019 and the rate outlook consequently shifts upwards, loans stand to benefit from their short duration structure, and from the inflows that typically

Scott BaskindHead of Global Senior Loans and Chief Investment Officer Invesco Senior Secured Management Inc.

“Historically, senior secured loans’ overall coupon, not net increases in reference rates, have been the primary driver of returns.”

1. Credit Suisse Leveraged Loan Index as of March 31, 2019. 2. JP Morgan as of March 31, 2019. 3. Average ultimate recoveries, Moody’s Research published February 2019. For Institutional Investor Use. The market for senior loans can be illiquid and could be disrupted in the event of an economic downturn or a substantial increase or decrease in interest rates. Senior loans, like most other debt obligations, are subject to the risk of default. This is being provided for informational purposes only, is not to be construed as an offer to buy or sell any product or financial instruments and should not be relied upon as the sole factor in any investment making decision. The opinions expressed are those of the author, are based on current market conditions and are subject to change without notice. Invesco Advisers Inc. 05/19. NA4380