Investors eager to enhance their portfolios might want to consider putting some money into U.S. senior loans, as suggested by Nuveen. These financial assets are essentially debt instruments issued by prominent companies like American Airlines and Restaurant Brands, the parent company of Burger King. They fall below investment-grade, which adds a certain risk factor. Structured and syndicated by banks, these loans are distributed to large groups of lenders, such as mutual funds and institutional investors. Often referred to as syndicated loans, floating rate loans, or bank loans, senior loans usually feature floating interest rates linked to the Secured Overnight Financing Rate (SOFR). Currently, these yields can exceed 8%.
Nuveen highlights that the Bloomberg U.S. Leveraged Loan Index, with a coupon rate of 7.99%, shows a yield to maturity of 8.5% and a yield to a 3-year term of 8.63%. Scott Caraher, Nuveen’s head of senior loans, emphasized in an interview that these are a potent asset class for various reasons. Notably, they don’t carry interest rate or duration risk, although investors should be mindful of the credit risk involved by carefully evaluating the issuers. Being at the top of the capital structure also means senior loans are prioritized for repayment if any issues arise.
Despite expectations that the Federal Reserve might lower interest rates further this year, Caraher argues that senior loans can adapt to any interest-rate environment. "You can’t time the markets," he advises, hinting that this asset class might suit a permanent allocation in one’s portfolio, akin to investment-grade or high-yield bonds.
Nuveen has provided five compelling reasons to be optimistic about senior loans:
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Compelling Risk-Adjusted Return: With one of the highest yields in fixed income and low sensitivity to interest rates, senior loans shine from a yield-per-duration perspective. According to Nuveen’s December analysis, they boast the top risk-adjusted return in any fixed-income asset category, supported by Morningstar data.
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Resilience: Over the past 31 years, the U.S. loan market achieved positive returns in 28 instances. Nuveen points out that senior loans also showed positive total returns in eight out of nine years during rate cuts by the Federal Reserve.
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Portfolio Diversification: Senior loans exhibit low correlations with other major asset classes, such as only 0.15 compared to high-quality U.S. bonds and 0.60 to U.S. equities. In comparison, high-yield bonds show higher correlations of 0.48 and 0.80 against high-quality bonds and stocks, respectively. Thus, adding senior loans can enhance portfolio returns while reducing volatility.
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Liquidity Provides Flexibility: Actively traded on the secondary market, these loans provide the flexibility for portfolio managers to shift positions for either risk management or potential returns. This liquidity allows for real-time asset allocation instead of being tied up for several years.
- Mainstream Acceptance: The U.S. loan market has grown to $1.4 trillion, surpassing many staple fixed-income classes like emerging-market debt. The growth is fueled by collateralized loan obligations (CLOs), which now constitute about two-thirds of the investor base. Institutional investors make up around 30%, offering market stability.
For individuals interested in entering this market, senior loans are accessible through exchange-traded funds and mutual funds, whether open or closed-ended. For instance, T. Rowe Price Floating Rate ETF has garnered a Gold rating from Morningstar, showing a 7.32% 30-day SEC yield and a 0.61% expense ratio.
According to Tom Graff, chief investment officer at Facet Wealth, selecting a fund should involve a keen look at the team managing it. Understanding how these managers performed during market downturns, like in 2008, is essential to gauge whether they adopt a safer or more aggressive approach. Considering credit rating allocations and exposure to senior loans alongside other investments like high-yield bonds is vital.
Attention should also be given to any fees, particularly performance fees, which could detract from returns. Active management is crucial, as Nuveen’s Caraher emphasizes, because adept managers can identify risks and manage them effectively. Historically, the default rate has hovered around 3% annually, but skilled management can reduce it to about 1% to 1.5%.
Caraher recommends an open-end, daily-liquidity mutual fund such as the Nuveen Floating Rate Income Fund, offering a 30-day SEC yield of 7.74% at a 0.78% expense ratio. With 85% of the fund in actively managed loans and about 15% in high-yield bonds, Caraher believes senior loans could comprise 5% to 15% of a portfolio’s fixed-income exposure.
Tom Graff concurs, suggesting senior loans can replace part of a high-yield allocation. "It’s a good complement," Graff remarks, citing the lower risk tied to their higher position in the capital structure and floating rate.
