How senior secured loans can help community banks manage risk in market storms

It’s been an interesting and tumultuous year for the broader loan market, with the Federal Reserve launching its most aggressive rate hikes in decades. Senior loans have not been immune to macro volatility, but they have held up better than most other asset classes year to date (Figure 1), benefiting from their floating-rate, short-duration structures.

However, some banks remain cautious on senior loans, given that many loans are currently trading below par. In this regard, senior loans may be a victim of their own pricing transparency: Unlike other loans on bank books, senior loan values are informed by a relatively liquid and large secondary market and heavily influenced by the trading activity of large investors like CLO buyers.

For bank lenders, it’s critical to understand that market price volatility has complex drivers and isn’t necessarily an indication that fundamentals are broadly untenable. Volatility may simply reflect an imbalance of supply and demand among large loan buyers. In periods of significant uncertainty—whether driven by interest rates, the economy or other shocks to the market—buyers negotiate with sellers to trade loans on the secondary market. If sellers outnumber buyers, loan prices may fall, as seen most significantly during the financial crisis and the 2020 pandemic (Figure 2). As such, loan values can be influenced by the market’s appetite for risk in times of uncertainty.

Loan values may also be pressured by ratings migration and the proportion of downgrades to upgrades. These factors tend to affect lower-rated loans more significantly than higher-rated cohorts. In 2022, for example (shown in the right chart above), prices of BB– loans reacted only modestly to speculation of rising rates, whereas B– loans had a more severe negative response.

Credit with different ratings may have different sensitivities due to demand and supply for each cohort, especially relating to the speed and magnitude of rate policy, potential knock-on effects to credit fundamentals, and, ultimately, the market’s view of a return to calmer waters.

Historically, market values tend to revert to par (or even marginally exceed par) for performing loans after market turmoil subsides. As the Fed nears the end of its tightening cycle, we expect prices for senior loans to slowly return to pre-rate-hike levels. We base this view on two things: the current state of loan fundamentals (particularly for those rated BB– or better), and the behavior and influence of key buyers in the loan market.

Rapidly rising short-term rates should, all other things being equal, increase borrowing costs for senior loan issuers. Therefore, an aggressive rate-hike cycle could pressure interest coverage ratios, particularly if earnings begin to degrade in a recessionary environment. While this risk has risen, we believe company earnings, cash flow generation and liquidity appear reasonably supportive overall for the loan market, and particularly for the BB cohort.

As it stands today, default risk is rising slowly but remains very low, with default rates of just 0.6%, compared with a long-term average of just under 3.0%.1 Moreover, defaults within the BB cohort, which represents bank-appropriate risk, have been consistently much lower than within the broader loan market (Figure 4). Only 2009 (the global financial crisis) and 2020 (the pandemic) stand out for their notably higher default rates. On a cumulative basis over the past 10 years, loans originally rated BB accounted for just 12% of all loan defaults (by issuer count).

In framing our outlook, we point to a few observations:

• Among a sample of 153 public loan issuers tracked by LCD, the weighted average interest coverage ratio remained healthy at 5.6X as of June 2022, supported by solid year-over-year EBITDA growth of 11%.
• Most issuers appear to have reasonable headroom to absorb increased borrowing or a decline in earnings should the economy enter a mild to moderate recession.
• A prolonged recession would likely increase defaults, particularly in certain sectors and among the most leveraged issuers. (A portion of that “loss-given-default” risk appears to be already priced into the market.)
• While today’s historically low default activity is likely to tick up at some point, we see no indications that the increase would be widespread, and we expect stress to be concentrated in certain sectors. (BB rated credit should exhibit even less stress than lower-rated cohorts.)

In general, demand for CLOs tends to wane along with demand for broader risk assets in times of economic uncertainty, particularly in the face of a potential recession. During such periods, market values for loans may trade lower as CLO issuance slows. With recovering market sentiment, new-issue activity builds, cash re-enters alternative markets, and prices tend to rise. Therefore, even though banks should focus primarily on credit fundamentals, relative value and sector risks when making loan trading decisions, understanding the influence that CLOs have on the broadly syndicated loan asset class can better inform their view of the broader risk and opportunity set.

Bank credit risk management practices must measure the potential downside of external events and provide for action if necessary. However, we don’t believe a potential shift lower in credit ratings would indicate that banks are likely to see a meaningful rise in defaults within their portfolios.

Moreover, the senior and secured nature of the asset class has historically supported total returns over the long term. Performing loans tend to retrace market value losses quickly after periods of technically driven dislocations. Meanwhile, defaulted loans typically experience better recoveries than subordinated and unsecured assets, as they have the backing of borrower collateral.

For long-term investors, we believe higher-biased quality cohorts (BB and better) offer attractive relative value in most economic environments. The value is especially relevant for banks that are struggling to attract reasonable levels of commercial and industrial loans, or that have a high concentration in commercial real estate loans and single-family mortgages, where volumes have been dropping. We have confidence that senior loans can be an effective alternative.

There are three key questions bankers should ask when assessing the addition of a senior loan portfolio:

1. How do the variable rates and relatively short durations of these loans fit within the bank’s asset liability strategy?

2. How does the bank measure the tradeoff between locally sourced loans and purchased loans regarding strategy, culture and internal credit resources?

3. Finally, can the bank measure the value of senior loans relative to its new local or alternative production of all loans and interest-earning assets? Where do these fit, and at what level should the bank manage concentration and set policy parameters?

We welcome the chance to explore these questions with you further. To learn more about the opportunity in senior loans, please contact your Voya representative.