Key Takeaways
Variable-rate senior secured commercial and industrial (C&I) loans offer reduced default risk, less sensitivity to interest rate changes, and a strong secondary market— all of which may benefit community banks and help them remain competitive.
To incorporate these loans in their portfolios, smaller banks should review their credit policies for inclusion of senior secured loans and have resources in place to manage corporate lending risks.
Voya Investment Management partners with community and regional banks to help them make informed decisions and ensure that each loan meets high standards.
How can community banks remain competitive and avoid consolidation? One solution is to add variable-rate senior secured commercial and industrial loans to their portfolios.
Bank consolidation may have a big impact on the economy
Rate and credit cycle struggles and ever-advancing regulation are likely to accelerate consolidation, a trend that we have been helping our community bank clients navigate. Some institutions failed to incorporate fundamental economics and core asset/liability gap management banking principles, and the fallout may have far-reaching impact—including consequential new regulations. The collapse of these banks grabbed headlines and raised concerns about broader risks in the regional and community banking systems. What are the consequences of a shrinking community bank market within rural areas? How can banks add loan growth efficiently—and with improved risk awareness and stewardship?
While the ultimate fallout of bank collapses in the past several years remains to be seen, two things are certain:
- Banks with more diversified loan books should be in better condition to withstand periods of volatility. Historically, banks that have come under the most pressure have had concentrated positions in low-yielding (lower than current market rates), long-duration securities and loans with fixed rates. When interest rates rose sharply (shifting the yield curve), assets subject to mark-to-market values plummeted—and trouble escalated from there.
- Banks that managed their securities’ concentration levels and maturities to address potential interest rate movements likely mitigated their “accumulated other comprehensive income” (AOCI) positions and the consequential impacts on liquidity and equity.
Why incorporate variable-rate C&I loans?
Variable-rate C&I loans are an established asset class and represent a core capital market that is active and growing. Many community banks acquire these loans as a strategic layer of their portfolios. In the current environment, these loans also present a compelling opportunity for banks looking to diversify their portfolios and minimize exposure to interest rate risk.
Variable rates minimize interest rate risk
Senior secured loans are floating rate—meaning their coupons reset as the prevailing index (SOFR) changes. Some loans are structured with SOFR floors, meaning that if rates cycle very low, the yields will have a protective synthetic floor.
Variable-rate C&I loans have a history of low default rates
Senior loans’ history of low defaults is partially due to their senior secured status. The loans have the most senior claim on all the borrower’s assets in the event of bankruptcy. The chart below shows instances of defaults by broad rating cohort in the U.S. loan market since 2000. The orange bars represent bank-appropriate credit risk, while the gray bars represent higher B grade credit risk. The blue bars represent all default incidences in the market.
To be fair, a loan that is stressed may sell at a below-par price. But if a bank employs best practices and looks to divest a loan at early signs of stress, there is a good chance it can sell near par and avoid that potential problem. Compare this scenario with a loan that a bank has acquired from another bank and now wants to sell. About the only option would be to sell the loan back to the original bank—which may or may not want to buy it.
As of 12/31/24. Source: LCD, Voya IM.
How can community banks benefit from holding senior loans?
In terms of risk-adjusted returns, a syndicated portfolio compares favorably with a typical local C&I small market portfolio. A bank may acquire a portfolio of loans with a near investment grade weighted average quality yet enjoy margins comparable to its quality C&I relationships. Additionally, these loans are much more efficient to originate and service.
Traditionally, large money center banks enjoyed access to this asset class—and would invite other banks that could take large, efficient positions in these loans and help the transactions to complete their syndication smoothly. Meanwhile, community banks had difficulty accessing the syndicated loan market due to the size and scale required to sustain a corporate lending function within their institutions. But this has been changing.
Voya Investment Management works directly with agent banks to consolidate all the borrowers’ data, such as agent information memoranda and third-party industry, borrower and economic data. We share our complete bank-like underwriting work product with our client banks. The institutions that initiate and acquire these loans also analyze and re-underwrite them to their own standards. Additionally, ratings agencies also review and rate these transactions, and regulators review them during the Shared National Credit exams. Ultimately, any given transaction is examined and scrutinized by numerous highly experienced analysts and attorneys.
Within this spectrum, there is a clear and large volume of bank-appropriate loans in the market. There is always a possibility of a black swan event occurring; however, even if it does, when examining how these transactions weathered the past several years (relative to a regional middle-market portfolio), this market remains a good place to have C&I exposure. The relative value and efficiencies of senior loans, combined with liquidity and flexibility that banks simply don’t have with a local C&I portfolio, indicate these loans are earning assets that community banks should consider.
About senior secured loansBorrowers in the senior loan market are typically national or large regional companies. They have some inherent advantages over smaller borrowers, including operations that span multiple economic regions, large customer bases, deep supply chains, access to multiple public and private capital markets, and staying power in tough times. Loan terms are generally five to seven years and amortize in whole or part. They generally have strong, proven cash flows and attractive interest coverage ratios. Although many borrowers are leveraged at levels higher than their investment grade counterparts, the debt is typically secured by a first lien on all assets. These loans are typically originated by the largest banks in the country. The origination process involves a sponsor (or borrower) that initiates the transaction with an agent bank. That bank structures and negotiates the transaction—ultimately setting pricing and timing—and then gathers a syndicate of other banks and institutions to complete the transaction. The institutions that acquire large portions of the transaction include larger commercial banks, asset managers and other institutional investors. Once a primary loan transaction has closed, a senior loan may trade in a very deep and active secondary market; banks can acquire the loan from one of the syndicating banks, or an institution can divest a loan that it previously acquired. In other words, there is always a liquidity outlet. |
Considerations
A carefully selected portfolio of senior loans acquired to meet or exceed bank policy can be a strategic complement to an existing bank portfolio. Regulators favorably consider a loan purchase program that demonstrates conservative quantity and credit structure, thorough risk identification and mitigation, and aggressive monitoring.
However, before a community or small regional bank makes the leap, there are several factors to consider.
- Is your growth and asset mix (particularly loan type and concentration) consistent with your credit policy?
- Are there other lending opportunities in your market, and are they available within your footprint?
- Do you have the internal resources to assess and manage corporate lending?
We are here to help you explore the answers to these and any other questions you may have about adding senior C&I loans to your portfolio. Contact us here to learn more about the opportunities within this asset class.