A senior bank loan is a loan made by a bank or other financial institution to a company with a relatively low credit rating, but a rating that is somewhat higher than that of a company that would be considered an issuer of junk bonds.
Senior bank loans are also referred to as syndicated bank loans, as a number of them are usually packaged together, and the packaged debt obligation is then sold to investors.
The loans are designated as “senior” because they take priority over any other potential debt obligations by the borrower. It means that senior bank loans are the first debt repaid from a borrower’s assets in the event of default, bankruptcy, or liquidation.
Senior bank loans are repackaged debt obligations comprised of several loans that banks make to companies with lower credit ratings. They are secured loans that come with repayment priority over other debt obligations.
The possible return on investment from investing in senior bank loans is typically higher than the returns from investment-grade bonds but lower than the returns possible with junk bond investments; the credit risk with senior bank loans is in accordance with this – somewhere in the middle.
Investors usually access investments in senior bank loans through mutual funds or ETFs.
Characteristics of Senior Loans
Again, senior bank loans occupy the top rung on the borrower’s capital structure, which means they are first in line to be repaid, taking priority over all other debt obligations of the borrower. This makes such loans a fairly secure investment, although they are not totally risk-free. Senior bank loans are usually secured loans secured with collateral. The collateral may be in the form of land or property, equipment the borrower owns, or inventory.
However, because these loans are typically provided to companies with lower credit ratings, they are considered non-investment-grade. In terms of risk, senior bank loans are generally considered riskier than investment-grade assets such as Treasury bonds, but less risky than high-yield or junk bonds.
The investment returns possible from investing in senior bank loans falls in line with their risk category. That is, they will generally offer higher returns than investment-grade bonds but lower returns than junk bonds.
Applicable Interest Rates
The interest rates on senior bank loans are typically floating rates that are periodically adjusted. The rates are usually benchmarked to a short-term interest rate such as LIBOR (London Interbank Offered Rate) or the Fed Funds Rate – the overnight lending rate offered between banks in the United States. The interest earned on senior bank loans is how investors receive their return on investment.
The floating, adjustable-rate nature of the debt obligations means that they provide investors with additional profits in the event that interest rates rise while the debt obligations are held. However, it also means that investors will receive a lower yield if interest rates decline over the term of their investment.
Investing in Senior Bank Loans
Investors can purchase senior bank loan debt obligations through a brokerage firm, but that practice is only recommended for knowledgeable and experienced investors. The more commonly used avenues for investing in senior bank loans are investing in either mutual funds or exchange-traded funds (ETFs) that invest in such debt securities.
An important point for investors considering senior bank loan investments to keep in mind is the liquidity risk involved. The market for senior bank loan securities is comparatively small and, therefore, is not extremely liquid. It is significantly less liquid than either the stock market or the bond market.
Because of the fact, when a fund manager goes to sell senior debt securities – such as when the fund needs to liquidate some investments to fund withdrawals by investors – he or she may be forced to accept a less than ideal sale price. That, in turn, would negatively impact the fund’s value.
Investments in senior bank loans offer investors a means of diversifying their overall fixed-income investment portfolio. Such investments can serve to increase the overall yield earned on fixed-income investments and also reduce volatility in your fixed-income portfolio.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:
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