Senior protection

Sandra Haurant looks at how pension fund investors have looked away from bonds to alternative fixed income solutions, in particular senior loans

Pension fund portfolios have evolved hugely over recent years. They have been moving away from more traditional compositions, while asset classes previously little known to the industry become new mainstays of pension investment. But while investment approaches develop and change, the needs of pension funds, of course, remain relatively constant. The necessity to balance performance and risk and to meet liabilities does not change, and fixed income investing has always played an important role in meeting their obligations.

But while in the past bonds, both corporate and government, have traditionally been the bread and butter of fixed income investing, the years following the financial meltdown of 2008 have seen a shift. It has become increasingly important for pension investors to look for alternatives that can offer the stability that is so crucial to their success, and investors have been searching beyond bonds to find the right fixed income solutions.

One asset class that has been growing in importance for pensions is the senior loan, also referred to as corporate loans or floating rate senior secured loans. Invesco defines this asset class as: “A privately arranged corporate debt instrument that provides capital to a company (usually below investment grade) and is syndicated to a group of banks and institutional lenders. These loans are structured, arranged and administered by a commercial or investment bank — known as arrangers. Loans are typically issued in conjunction with leveraged buyouts, mergers or acquisitions. The company’s payment of interest and repayment of principal on its bank loan is usually contractually senior to any other form of debt or equity.”

Protection?

In the past, this has been something of a niche area, but interest and popularity is picking up among pensions. “For some, it’s relatively new,” says Lyxor Asset Management UK head of debt fund management and managing director Thierry de Vergnes. “At this stage, it is mainly the larger pension funds that are already active in the asset class. But now many others are looking at this actively.”

The senior loan is not a new asset class, but it is only just beginning to make its name as a fixed income alternative within the pension investment community. And there are good reasons for this new interest, says Cardano chief strategist Hemmo Hemmes. “There are two main differences that make them attractive in their own right, and different from bonds,” he explains. “Firstly, they are higher up the capital structure, so they are secured by the assets of the company, which means you are ahead of other debt holders [if there is financial difficulty].

“Senior suggests a level of protection,” says Aon Hewitt partner Tim Giles. They are called ‘senior’ loans because they are higher up the capital structure and less vulnerable in times of financial crisis. Essentially, if a company has financial problems, loans are higher up the repayment pecking order and so investors are more likely to be reunited with their money.

And the second key aspect that makes them attractive, explains Hemmes, is their relationship with interest rates: “The other interesting feature is that the coupon moves around with the interest rate, so this is a floating rate instrument, and that means that when interest rates go up, whatever you get paid as interest goes up as well.” A rise in interest rates can, by contrast, wreak havoc in the bond market. Increasing interest rates usually spell a fall in bond prices, resulting in serious losses and lack of liquidity. Indeed, Hemmes explains: “If you hold a corporate bond, or any bond, when interest rates go up you are sitting on a loss. Whereas [senior loans] give you protection from rising interest rates.”

For Hemmes, the additional protection offered by senior loans against increases in interest rates provides significant appeal, and makes them a more attractive proposition than bonds. “If you have to choose between corporate bonds on one hand and loans on the other hand, then if you are expecting rising interest rates then loans are more attractive than bonds. It gives you more protection against rising interest rates,” he says. After all, says Giles: “The risk is selling at a time of market stress; senior loans do not suffer to the same degree.”

De Vergnes expects interest rates to rise in the next five to six years, at which point loans could really come into their own. But, he argues, we have already seen loans demonstrate their stability compared with bonds this year: “When [US Federal Reserve chairman] Ben S Bernanke announced tapering, we saw the bond market moving down five to six points, but the loan market moved by a point, maximum.”

Growing interest

And with many forecasting a rise in interest rates in the medium term, the appeal of senior loans is growing. The potential for this level of stability is clearly enormously attractive to the pensions market, and the appetite for yields makes these an appealing option. Yields on senior loans typically compare well with those of bonds, and although they may pay slightly less than high yield bonds, their place in the capital structure means they offer a decent risk to return ratio. “That is why I am optimistic that this asset class will grow, because there is a natural transition from bond to loan as there is no cost in terms of yield,” says de Vergnes.

Precisely because of the benefits they have demonstrated, particularly compared with bonds, prices for senior loans have risen but, Hemmes argues, there is still value to be found, particularly on this side of the Atlantic: “Valuations have been driven higher in the US, but in Europe there are pockets of opportunity, and we expect interest rates to increase over time so that will affect loans versus bonds decision.”

There have been some concerns about illiquidity within the senior loans market, but de Vergnes argues: “Loans are not that illiquid – you still have the ability to trade. You have to work differently, but you have possibility to move paper. There was around €40 billion in loans traded in 10,000 transactions last year.”

Interest in the asset class is increasing, but ways of investing in this new area vary depending on the size and shape of the pension schemes. While some of the very largest schemes may invest directly in loans, for many that would not be a feasible option. “They would either need a massive portfolio in order to get the diversity they need, or they would need to invest in a fund,” says de Vergnes.

An increasingly wide spread of funds is including senior loans in portfolios, particularly within debt funds, and, in fact, says Giles: “If you look at some of the diversified growth funds, you will see some of these in there.” And funds such as these come with advantages. “A plus point in investing in a debt fund is that you get some liquidity organised by the manager,” de Vergnes adds.

As a relatively new area of investment for pension funds both large and small, for many trustees there is something of a learning curve to undergo. “We are in education phase,” says de Vergnes. “I would say second phase of education. Clearly it’s moving in the right direction; the economics are clear in terms of margin and what has happened recently on the bond market should also be a pretty compelling argument.”

Hemmes says that clients of Cardano have been largely positive and interested in moving towards senior loans, and he argues that their very nature is reassuring. “The key feature is relative stability of returns, and because you are high up in the capital structure you wouldn’t expect to lose too much if we end up in a recession. So, taking a long term view, that is really attractive,” says Hemmes.

Sandra Haurant is a freelance journalist

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