As Thanksgiving Day approached, we took the measure of the markets in hopes of finding something for which we could give thanks. Lemme tell ya, folks: Pickin’s are pretty slim. No matter how you slice the equity market—domestic or international, growth or value, utilities or industrials—it seems that all sectors are in the red for the year. The fixed income market isn’t much better, though there is a segment that clearly stands out for generating positive returns while others faltered. That’s the senior loan market.
Senior loans, otherwise known as bank loans or leveraged loans, are syndicated credit facilities with variable coupons. Senior loans are typically medium-term, most often with original maturities of seven years. Commonly, interest rates are pegged to three-month Libor and reset every 90 days, bestowing them with minimal interest rate risk.
These credits earn their “senior” designation because of their position in a company’s debt structure. Because they’re typically collateralized by a specific corporate asset, bank loans are prioritized above a company’s unsecured bonds and preferred stock. While this mitigates some default risk, senior notes are generally rated as “junk”.
Investors are now giving thanks for the floating rate feature of these notes. As Libor has ticked up this year, so too have senior loan coupons. The Libor reference rate started the year at 1.44 percent. At last look, Libor had climbed to 2.65 percent. Now that may not sound like much of an uptick, but you have to realize that senior loan covenants specify a “spread” over Libor for coupon payments. For example, a loan syndicated with a spread of 250 basis points over Libor and due for reset today would now pay 515 basis points or 5.15 percent.
Better still, there’s often a “floor” built into bank loan agreements, stipulating a minimum reference rate. If our note had a 100-point floor and Libor had fallen to, say 90 basis points today, the spread would be applied to the 100-point floor rather than the prevailing Libor rate, making the new coupon 350 basis points. Pass the cranberry sauce, please.
