If “location, location, location” is the maxim for success in real estate, “structure, structure, structure” is the equivalent adage when investing in senior secured loans.
If you read the cover of any prospectus used to offer a fund that invests in senior secured loans, you will surely find a disclosure stating this type of debt is “considered speculative and involves a high degree of risk, including the risk of a substantial loss of investment.” Yet, investment in senior secured loans has continued to trend upward, predominantly due to today’s low interest rate environment and the relatively higher yields that this asset class can offer.
So how can investors better protect and position themselves for positive outcomes when investing in loans? Structure. Structure. Structure.
Credit agreement structure: Control the outcome
If things start to take a turn for the worse, senior secured loan investors don’t have to simply be passive participants. First, it is important to highlight that loans are not securities. They are contracts, and contracts have terms. These terms can be negotiated, but more often than not it’s the lender that ultimately sets the terms. As they say, the one who has the gold sets the rules.
In a loan contract, or credit agreement, the terms go well beyond simply setting the interest rate and maturity date to include covenants that place certain standards of performance and behavior on the borrower. Generally, if a borrower violates a covenant, they may experience a default. In a default situation, lenders are often able to exercise their rights and seek to protect and preserve their economic interests.1
This first aspect of structure provides an element of control. The credit agreement often gives loan investors a means to bring about change and help preserve their investment.
Capital structure: Protect your downside
The second element of structure that can help mitigate risk is to invest at, or close to, the top of a company’s capital structure.
First and second lien senior secured loans generally sit at the top of the corporate capital structure, meaning they are first in line to receive payment – before unsecured bonds or equity. Because of this priority of payment, principal tends to be more secure than other forms of corporate debt, with significantly lower loss rates in the event of a default than subordinated or unsecured bonds. Further, loans can have liens on tangible and intangible assets (cash, accounts receivable, property plant and equipment as well as trademarks and patents, just to name a few types of assets). These liens can provide additional control and potential for principal protection if the investment doesn’t go as planned.
Investment structure: Don’t be a forced seller
Finally, how you invest in senior secured loans can significantly impact your returns. Most of us invest the bulk of our portfolio in “pooled investment vehicles” like mutual funds. On balance, mutual funds have been a tremendous boon to the investing public. They provide access to many different investment strategies and asset classes, can be used for indexing or active management and democratize access to professional managers. Further, they can easily be bought and sold every day.
However, that very ease of access can present a significant risk if a liquid, open-end mutual fund is used to access a more illiquid asset class, such as senior secured loans. Loans, especially during periods of market dislocations and volatility, can become highly illiquid. Howard Marks, one of the co-founders of Oaktree, summed up the transitory nature of liquidity: “things tend to be liquid when you don’t need liquidity, and… just when you need liquidity most, it tends not to be there.”2 This sentiment is particularly true when it comes to loans. On average, loans take over 19 days to settle.3 For reference, mutual funds typically settle in one day and stock trades typically settle in three days. As a result, many open-end mutual funds are forced sellers in volatile markets, because they often must contend with investor redemptions (a rush to the exits) and generate cash in a short period of time.
A surefire way to lose money when investing in credit is having to be a forced seller. If an open-end fund manager needs to liquidate loans to generate cash for redemptions in a volatile market, chances are they’re going to have to sell their most liquid, and oftentimes best performing positions. Even if you’re not one of the mutual fund holders that seeks a redemption, you could still lose since the portfolio of assets that remains may not be of the same quality.
Again, structure matters. Investing in a vehicle that may not have daily liquidity, where the manager can invest for the long term, may generate better returns and protect you in downside situations.
So, remember, the next time you’re evaluating a credit investment, think structure, structure, structure. Consider the terms and structure of the credit agreement. Understand where in the corporate capital structure you’re making your investment – the more senior you are tends to have higher recovery rates and lower loss if things go wrong. Finally, think about the investment structure you’re using to access credit. If the asset class is relatively illiquid, traditional mutual funds may not be your best bet.
1 Defaults may result in various outcomes including a corporate restructuring or bankruptcy. While lenders have the potential to preserve their economic interest, a corporate bankruptcy, a default or restructuring can also result in significant losses, and below investment grade securities, such as senior secured loans, may experience higher default rates compared to investment grade companies.
3 Thomson Reuters LPC, http://reut.rs/29i66UZ.
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