Tapping into the potential of senior secured loans

Tyndall Asset Management’s Tim Martin writes that senior secured corporate loans are an investment that has performed well and should not be overlooked by superannuation funds.

The global financial crisis (GFC) tested most traditional financial and investment strategies, with a number coming up wanting.

One, however, that has performed well (and continues to do so) is senior secured corporate loans – either through direct investment or through loan funds or securitised vehicles.

Corporate lending of this kind predates the rise of bond and equity markets by centuries; however, senior secured loans as a mainstream asset class have only recently gained serious recognition amongst institutional investors in Australia, although the sector has been popular in the US for some time.

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Furthermore, it is an asset class that is progressively opening up to investors, thanks to a number of events that have seen the banks – the traditional source of finance for corporates – increasingly challenged in this sector.

Until a few years ago, commercial banks dominated lending to this market, leaving little opportunity for investors.

However, the reluctance of banks to lend to medium-sized business, coupled with the increasing pressure on bank balance sheets from the implementation of Basel II and III capital adequacy rules, has meant they are less active in the sector, helping to open it up to investors.

This investment opportunity gives investors access to the top of the corporate liability structure, compared to government, corporate or high yield bonds which are generally unsecured or sometimes subordinated.

Generally speaking, it is an income-based opportunity driven by consistent income generation and capital stability over the cycle.

Indeed, the performance of senior secured loan investments through the post-Lehman GFC – the most challenging credit environment since the 1930s – has confirmed the durability of these investments from a credit perspective.

For such reasons, many institutional and individual investors are starting to view senior secured loans as a permanent component of a fixed income investment allocation.

However, unlike other fixed income such as bonds, senior secured loans have a different risk/reward profile.

Bond investments combine both credit and interest rate risk – although the higher the credit quality of the borrower, the more the bond becomes a directional bet on interest rates.

Senior secured loans, on the other hand, are the highest ranked debt of the issuer and are often secured by collateral such as property, debtors, inventory, plant and equipment. In the event of a default, these loans will typically recover at a higher rate than bonds of a like credit.

Recoveries for loans after a bankruptcy or receivership is almost double that of high yield bonds. In other words, credit losses are less than half those experienced by unsecured or subordinated high yield bond investors.

The attractions of senior secured debt are now increasingly being recognised, with the market crash and de-leveraging since 2008 having raised the profile of the loan asset class.

This is particularly true in the US, where it has continued to offer investors competitive returns.

Nonetheless, these returns are not without attendant mark-to-market volatility during that period because of the widely held nature of loans in that index and a default rate which reached 11 per cent.

At the same time as US and Australian investors increasingly recognise the benefits of the senior secured loan asset class, opportunities to invest in the asset class are also expanding.

Banks globally are surrendering access to the corporate loan market, having been restricted by both the credit impact of the European sovereign debt crisis and euro zone instability, as well as the ongoing structural restriction on their ability to lend to the corporate sector against assets other than property.

As previously mentioned, Basel II and III rules have hastened this disintermediation for institutional and retail investors.

In Australia, with corporate lending historically dominated by the four major banks and the foreign banks, direct access to the market has been probably even more limited than it was elsewhere.

However, as Basel capital adequacy requirements start to impact on the banks, entry for non-bank lenders to the $700 billion business lending market has grown.

While local Australian banks and those foreign banks that remain in the market continue to focus on the larger investment grade corporate borrowers, it seems that things are changing in the small and medium sized corporate market, which is a market of significant size.

According to the Reserve Bank of Australia (RBA), at May 2011 more than 50 per cent of the business lending market was represented by small and mid-size corporate borrowers.

Business credit growth in Australia continues to be subdued, although the RBA estimates there was 2.3 per cent growth in the year to April 2012.

While these growth rates will probably stay at low levels in Australia for some time, it is likely that over the next few years there will be strong refinancing pressure across the business lending sector.

This will continue to create attractive pricing opportunities in the senior secured lending sector.

Australia’s situation

Australia has been one of the best performing economies compared to other developed world economies since 2008, with solid growth rates, low unemployment, positive terms of trade and low inflation, despite what is described as a ‘two-speed economy’.

At the same time, however, global funding pressures are continuing.

Our banks still have relatively high wholesale funding costs – in part, because of the need to hold more liquid assets.

Combined with the retreat by foreign and regional banks from the business lending market, borrowing costs have been driven higher relative to our stable/declining interest rate environment.

The result is that credit approvals for business loans greater than $2 million have fallen more than 26 per cent between December 2007 and December 2011, according to RBA statistics on bank lending to business.

This decline is around two per cent below the average for other G6 countries, and an enormous 68 per cent below the average of the Brazil, Russia, India and China (BRIC) economies.

This fall also reflects the Australian banking sector’s bias towards property-based lending.

It has therefore established an attractive pricing opportunity for other lenders to the sector.

In the current interest rate environment, senior secured loans to mid-market companies, who have used property, debtors, inventory or plant and equipment (often a combination) as collateral, can achieve all-in returns of 11 per cent plus.

These loans are usually three to five years, from $5 million upwards in size, and can be structured on a bullet, amortising or partially amortising basis with both floating and fixed rates of interest, including built-in interest rate floors and equity linked fees. 

Opportunities for investors

The likelihood of the historically low interest rates around the world being preserved by central banks for the short to medium term suggests that markets have a sceptical view on economic growth for the next two or three years.

The subsequent impact on government bond yields in Australia (and other countries where government debt default risks are low) is now evident.

The big challenge for governments and central banks in the euro zone will be to limit the fallout from any members leaving the European Union and the inevitable investor losses.

It is vital that banks and government authorities keep money markets from freezing, and recent events suggest that there is some collective will to save the euro zone.

Therefore, if we expect that Europe will work its way through its problems, and the US will continue to build on its signs of recovery, will a prudent approach to investing in privately negotiated, senior secured loans result in competitive returns versus equity and government bond markets in the coming years?

In our view, senior secured loans are the fixed-income sub-asset class for all seasons.

Aside from the structural issues facing banks as outlined above, there are other reasons to be positive about the sector.

Corporate and personal balance sheets in Australia have gone through significant deleveraging in recent years, and the strength of the high grade corporate market is self-evident from the fact that yields on some corporate debt have fallen below those of many top rated sovereign issuers.

The structural seniority of secured loan investments – combined with floating interest rates and interest rate floors – is an attractive combination that is likely to perform well in various types of economic scenarios.

The uncertainty around long-term economic growth, stock volatility, financial weakness among many governments, and the ultimate prospect of rising inflation, means that short dated or floating rate senior secured loans are well placed to perform well as part of the broader fixed income allocation.

Tim Martin is head of alternative assets at Tyndall.