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Senior Loans, Positioning in 2019


CEFA was joined by Brian Good, Senior Managing Director, Co-Head of Tradable Credit at THL Credit. In this episode, Brian discusses why senior loans are a good way to invest based on their high income potential, low interest rate risk and lower volatility compared to core investments.

The following Q&A recaps the conversation that originally took place as part of CEFA’s podcast series which can be heard here.

Brian Good



CEFA: Welcome to CEF Insights, your source for closed-end fund information and education brought to you by the Closed-End Fund Association. My name is Diane Merritt. Today we are joined by Brian Good, Senior Managing Director and Co-Head of Tradable Credit at THL Credit. We're happy to have you.

Brian: Thank you very much.

CEFA: Brian, can you please give us an explanation of the key characteristics of senior loans and the benefits and risks they present to investors?

Brian: Sure, my pleasure. Senior loans are debt instruments typically issued by non-investment grade corporate companies. They're known as senior loans because they sit at the top of the borrower's capital structure, and therefore, have a payment priority in the event of default. But not only are they senior, but they are typically also secured, as well. Senior loans are typically secured by the borrower's assets, such as cash, receivables, inventory, property, and equipment. Finally, senior loans are typically structured as floating rate loans, meaning that the interest paid will move with interest rate fluctuations.

We believe senior loans provide several benefits to investors. They're an effective way to diversify an investment portfolio. As an asset class, senior loans typically have low historical correlation to other major asset classes, such as equities and fixed income. Performance is another notable benefit senior loans provide investors. The income potential and the low correlations to other asset classes contribute to an attractive performance over the past 20 years, having posted positive returns in 18 of the last 20 years, based on the Credit Suisse Leveraged Loan Index. Finally, senior loans may provide investors generally high income potential while maintaining low duration, when compared to bond and preferred stock investments.

As with any asset class, senior loans have certain key risks. Senior loans are typically issued by non-investment grade borrowers, therefore credit risk or the risk of non-payment may be greater. In addition, senior loans are generally less liquid than traditional fixed income investments, as well.

CEFA: Passive investment strategies and various asset classes have gained a lot of traction in recent years. THL Credit is an active investment manager. In the senior loan sector, what advantages do you see for an active manager with respect to managing risk and adding to performance?

Brian: Generally speaking, flexible portfolio construction is one of the biggest advantages in running an active strategy. Through defensive sector rotation and active credit selection, we believe we can deliver less volatility to complement higher returns versus the passive market. As an active manager, we are not beholden to an index or the market values of any given loan, therefore we believe we can better manage risk and add the performance. We can adjust our holdings to limit the impact of market downturns, which can help to preserve capital during various market conditions. Also, active management gives us more flexibility in times of volatility, wherein we can proactively shift positions during declines to manage downside risk.

In addition, we believe we are better positioned to capture value. We believe we possess the skill and patience to identify assets with upside potential at attractive income levels. Finally, we believe active investing gives us more freedom to focus on investing with an expressed objective, which in the case of our closed-end fund is attractive, consistent levels of current income.

CEFA: THL manages a traditional closed-end fund with ticker symbol TSLF. What advantages do you find in the closed-end fund structure with regard to managing a portfolio of senior loans, and how do you see this benefiting investors?

Brian: At Institutional Investors, we are more focused on the long game rather than the short-term market ups and downs. This allows us to take a deliberate and disciplined approach to TSLF. The non-redemptive nature of the closed-end fund structure enables us to be patient while our credit theses on certain investments play out over time. As I mentioned previously, senior loans typically offer less liquidity versus other major asset classes. As a result, we believe the closed-end fund structure may be the most effective way for retail investors to access senior loans.

That's not to say that open-end funds don't work, but the enhanced focus on liquidity for redemptions can impact investment decisions. In the closed-end structure, this allows us to invest across the senior loan universe without concerns of daily liquidity required to meet redemptions in an open-end structure.

Finally, the ability to use leverage is a benefit, we have taken advantage of in the closed-end fund structure. I'll give you an example from last year. If you noticed, we had been managing our leverage levels below the maximum allowable through most of 2018. However, when the market pulled back from October through the end of the year, we were able to increase our leverage in order to take advantage of some of the market opportunities resulting from senior loan open-end fund redemptions.

CEFA: The U.S. economic expansion is about 10 years old, and the Federal Reserve has recently put interest rate increases on hold. At what stage do you see us in the credit cycle?

Brian: We believe we're in the late cycle expansion stage of the credit cycle. However, we continue to expect economic growth through 2019 and 2020. We forecast inflation to remain comfortable in the U.S., which should allow the Fed to be accommodative. Given where we are in this credit cycle, we think current economic data, such as the strength in the labor market, point to a rebound in 2019 and 2020. The U.S. economy remains healthy, and we won't be surprised to see recent recession fears fade.

CEFA: Default rates are a key consideration in evaluating below investment grade credits. Do you see the relatively low level of defaults of the last several years continuing to be favorable?

Brian: Yes, we do. Current default rates are below 2% and have stayed well below the historical average of 3% over the last several years. The current backdrop of strong earnings, reasonably sufficient interest coverage levels, and the lack of short-term maturity should help keep default rates well below historical averages. That being said, we do expect default rates to be slightly higher in 2019 than they were in 2018, but we expect them to be more sector specific, rather than market-wide overall. That was why we believe our defensive sector rotation and active credit selection will help position us to find attractive opportunities for the TSLF fund.

CEFA: Given this, what is your outlook for the opportunities in senior loans?

Brian:

Fixed rate markets, including high yield, have rebounded year to date, but we believe they have also become more expensive. With that, we think the Fed's shift and investors' continued search for yield should bring attention back to senior loans. Currently, we're seeing yields in first lien senior loans between 5.5 and 6.5% based on three-month LIBOR which is currently around 2.6%. As a result, we think, from a risk return perspective, senior loans should continue to be an attractive investment. Our view is that U.S. credit spreads aren't telegraphing stress at this point. Senior loans are typically seen as rising rate investments, but we believe that's a misguided notion. At the end of the day, we are investing in below investment grade companies, and there will always be a spread premium associated with that. Therefore, from a return perspective, we think senior loans should be a valuable component of an investor's portfolio.

CEFA: How do you believe in allocation to senior loans as best position in an investor's diversified portfolio?

Brian: Generally speaking, we believe senior loans are a great complement to an investor's core fixed income portfolios. We believe there are four key benefits to senior loans for investors. First, attractive current income. Senior loans provide strong relative yields. Senior loans are generally below investment grade and have higher credit risk, therefore investors receive a premium over the yield that would be paid by investments in higher rated bonds.

Second, lower interest rate risk over all. Senior loans have low interest rate risk. They can provide a more attractive yield per unit of duration versus other short-term and intermediate duration investments. Compared to other fixed income assets, senior loan prices are generally less sensitive to changes in interest rates, because of their floating rate coupons.

Third, low correlation and low volatility. Historically, senior loans have shown lower and sometimes negative correlations and lower volatility compared to other core investments, making them an attractive portfolio diversification tool.

Last but not least, principal protection. Senior loans have historically exhibited higher recovery rates than their unsecured bond counterparts due to their position atop the capital structure, which typically provides the senior loan holder first priority claim on assets in the event of default.

CEFA: Brian, we appreciate that you have taken the time to join us today.

Brian: Our pleasure. Thanks so much.

CEFA:  We want to thank you for tuning in to another CEF Insights podcast. For more educational content, please visit our website at www.CFA.com.
 


Audio recorded 04/1/19.



Disclosure

Closed-end funds trade on exchanges at prices that may be more or less than their NAVs. There is no guarantee that an investor can sell shares at a price greater than or equal to the purchase price, or that a CEF's discount will narrow or be eliminated. CEFs often use leverage, which increases a fund's risk or volatility. The actual amount of distributions may vary with fund performance and market conditions. Past performance is no guarantee for future results.

Resources

Aberdeen Closed-End TV

Asset TV — CEF Channel

CEF Connect

Cohen & Steers CEFs Knowledge Center

Harvest — CEFA Channel

Legg Mason CEFs

Seeking Alpha — CEFA Channel


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