Senior Loan Funds' Low Interest-Rate Risk, Enticing Yields Come With Risks
Investors should watch out for senior loan products' considerable liquidity risk and increasing credit risk.
In today’s rising-interest-rate environment, senior loan funds’ low-interest-rate risk and enticing yields have made them alluring. Senior loans’ yields go up in lock step with short-term interest rates, offering an effective duration hedge, but they come with significant credit risks, as most of these loans are issued by companies rated below investment grade. Since 2010, their credit risk has gradually crept up. The relative debt loads to U.S. loan issuers’ cash flows had surpassed the precrisis high in 2016 and stayed at that level in subsequent periods through March 2018, according to S&P. The improving economic outlook and investor demand for yield facilitated this increasing debt load. Leveraged buyout activities and relaxing lending standards also contributed to this growth. On top of the credit risk, senior loans carry considerable liquidity risk.
The overall U.S. leveraged loan market leverage, measured by total debt/earnings before interest, taxes, depreciation, and amortization (EBITDA), is at its 14-year high, according to S&P. The preglobal financial crisis high was 4.9 times in 2007, which cratered to 3.7 times the following year. But this ratio slowly picked up and reached 5.0 times at the end of 2016, and it held steady at this level throughout 2017 and the first quarter of 2018. This elevated credit risk is partially offset by the issuers’ improved cash flow positions for debt service compared with 10 years ago. The average interest coverage ratio increased from 3.25 times to 4.75 times from 2007 to 2017, according to S&P. However, it is important to note that leveraged loan coupons float with interest-rate movements. If rates continue to rise, the interest coverage ratio is likely to decline.
Phillip Yoo does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.
Transparency is how we protect the integrity of our work and keep empowering investors to achieve their goals and dreams. And we have unwavering standards for how we keep that integrity intact, from our research and data to our policies on content and your personal data.
We’d like to share more about how we work and what drives our day-to-day business.
We sell different types of products and services to both investment professionals and individual investors. These products and services are usually sold through license agreements or subscriptions. Our investment management business generates asset-based fees, which are calculated as a percentage of assets under management. We also sell both admissions and sponsorship packages for our investment conferences and advertising on our websites and newsletters.
How we use your information depends on the product and service that you use and your relationship with us. We may use it to:
To learn more about how we handle and protect your data, visit our privacy center.
Maintaining independence and editorial freedom is essential to our mission of empowering investor success. We provide a platform for our authors to report on investments fairly, accurately, and from the investor’s point of view. We also respect individual opinions––they represent the unvarnished thinking of our people and exacting analysis of our research processes. Our authors can publish views that we may or may not agree with, but they show their work, distinguish facts from opinions, and make sure their analysis is clear and in no way misleading or deceptive.
To further protect the integrity of our editorial content, we keep a strict separation between our sales teams and authors to remove any pressure or influence on our analyses and research.
Read our editorial policy to learn more about our process.