Strong demand, favourable default outlook, and floating-rate payment structure adds to appeal of asset class
After a protracted period of ultra-low global interest rates, which included historic rate cuts spurred by the economic threat of the COVID-19 pandemic, investors are bracing themselves for a new cycle of policy tightening by central banks. Against that backdrop of rising rates, they’re looking for ways to shore up their fixed-income allocations – and that includes senior loans.
“Senior loans are quite unique in that the coupon structure is floating rate, so it resets typically on a quarterly basis, which gives loans very limited sensitivity to rising interest rates,” says Larry Holzenthaler, Client Portfolio Manager at Nuveen. Nuveen is the sub-advisor for the Symphony Floating Rate Senior Loan Fund (SSF.UN), which is one of the longest-tenured senior loan strategies in the Canadian market.
According to Holzenthaler, senior loan indices have descended roughly 2% year-to-date, compared to high-yield corporate bonds that have declined by nearly 10%; investment-grade corporates and other longer-duration assets, he adds, have lost even more. The difference, he says, stems from the fact that corporate bonds have a fixed-rate structure, giving them more duration risk and interest-rate sensitivity.
Holzenthaler says he’s seen strong demand from senior loans this year coming from retail mutual funds, where investors are looking for income, and the institutional CLO (collateralized loan obligation) market, which is driven more by a need to avoid interest rate risk. Supply has been more constrained relative to what would be expected given the high level of investor interest, mainly due to issuer slowdown in the face of ongoing geopolitical risks that first erupted in February and March.
“Companies or issuers are going to be patient with respect to raising capital when you have such high volatility in the market,” he says.
One point in favour of the senior loans market is an expectation of low corporate default rates through to the end of next year. That consensus comes through clearly in analyses coming from ratings agencies as well as major banks. And with the Federal Reserve expected to raise rates further in a bid to fight inflation, short-term interest rates are also expected to rise to a strong degree, making senior loans whose coupon payments are referenced to short-term interest rates more desirable.
“Most market participants expect significant upward pressure on short term rates in the near term,” Holzenthaler says. “So that should put some upward pressure for the coupon rates of loans to float higher.”
Against that backdrop, Brompton’s fund has done well. According to Michelle Tiraborelli, SVP & Head of Closed-End Funds at Brompton Funds, SSF.UN has significantly outperformed Canadian-listed senior-loan ETFs over the last year.
An analysis of data as of April 30 shows SSF.UN has exhibited 10-year trailing returns of 4.8%, compared to 2.4% for the single Canadian-listed loan ETF with a 10-year track record. A look at 1-year, 3-year, and 5-year trailing performance data also overwhelmingly shows the fund outperforming other ETFs listed on the TSX.
“SSF has been in the Canadian market for over 10 years, and it offers a pretty significant yield advantage, with the current distribution rate about 6.4%,” Tiraborelli says. “That’s helped by the use of some leverage in the strategy, which is targeted to about 35% of total assets.”
While giving investors exposure to the senior loan market in and of itself provides some advantage, Holzenthaler says active managers can potentially improve the risk-adjusted performance further with company-specific research and an understanding of how different factors, like higher input prices or interest rates, impact each issuer. To that point, having an experienced team managing a senior loans strategy creates a significant edge.
“Most managers are almost entirely focused on just avoiding downside risk. But we try to take a more balanced approach and more holistic view of the companies that we get involved with,” he says. “If we believe a company has a potential inflection point into the future where they’re improving operations, for example, we can decide to be a little more patient, as opposed to just focusing solely on avoiding risk or complexity.”