Senior Loans – The Search for Income in a Low Yield Environment
KJH CEO, Joel Clark, and Wellington Square Portfolio Manager, Jeff Sujitno, outline the investment case for Senior Loans in a low-yield environment. View recap of the discussion or read in full below.
With fixed income turned on its head by Central Banks and many traditional fixed income strategies finding it hard to produce attractive risk-adjusted returns, KJ Harrison’s investment team explains how investing in senior loans can diversify your portfolio and reduce volatility for capital preservation.
What are Senior Loans?
Banks provide senior loans to corporations for various reasons including capital growth, acquisitions and refinancing. They are ‘senior’ because the loan is the first priority in the capital structure and secured by company assets; resulting in lower losses from default. The income is generated primarily from interest coupon payments on the loans.
Senior loans provide relatively high levels of income to investors compared to ‘traditional’ fixed income securities as the issuing corporations are traditionally non-investment grade rated; although many are well-known corporations such as Virgin Media, Dell International, Restaurant Brands (Burger King and Tim Hortons), and Goodyear Tire. The U.S. syndicated and traded senior loan market is $1.2 trillion in size, equivalent to the U.S. High Yield bond market.
In the U.S. and across Europe, banks often syndicate all or a portion of a senior loan to other banks and institutional investors including mutual funds. KJ Harrison, with the help of its sub-manager Wellington Square Capital, invests in the best syndicates for the benefit of its private clients.
Role of Senior Loans in your Portfolio
As yields on middle-market debt come down, investors have turned to senior loan funds to generate higher returns. Historical data demonstrates that exposure to senior floating rate loans in a fixed income portfolio typically improves the risk-adjusted return due to reduced interest rate risk, as well as the lack of correlation to other assets.
Attractive Income Levels
Senior loans offer an attractive level of income in a low-yield environment where 5yr U.S. Treasuries and Canadian Government bonds are yielding less than 0.5% annually. One of the most attractive characteristics of senior loans is the floating rate coupon, which unlike traditional fixed income assets, reduces interest rate risk. Senior loan coupons are typically comprised of a fixed spread over a floating base rate such as 3-month U.S. Libor providing a natural hedge against rising interest rates.
Diversification and Reduced Volatility
Long-term returns of senior, floating-rate loans are predictable and stable. The benchmark of the KJH Senior Loan Fund, the Credit Suisse Leveraged Loan Index, has generated positive returns in 26 of its 28 years since its inception. The floating-rate characteristic of senior loans reduces the risk associated with changes in prevailing interest rates, providing stability and reducing overall volatility. These characteristics are key in providing diversification to your investment portfolio.
Canadian Investors Underexposed to Senior Loans
It is our view that Canadian investors are underexposed to senior loans. Due to the correction that resulted from the spread of COVID-19 in March 2020, investors can now also benefit from capital appreciation opportunities alongside the attractive yields of senior loans.
In Canada, the banks dominate the senior loan space by bulk-buying and syndicating Canadian dollar senior loans to other banks; rendering the asset class inaccessible to the retail investor universe. However, in the U.S. and Europe, senior loans are a well-established asset class; widely traded and available to institutional and retail investors.
The U.S. loan market is dominated by institutional investors – banks, insurance companies, pension plans and endowments – with retail investors making up only 7% of the overall market; providing an additional element to reducing volatility of the asset class. It is also advantageous that many of the biggest banks in the U.S. and Europe are invested in the same senior loan syndicates as many of their investors; effectively aligning their interests with that of their clients.
In the primary market, the supply of new issues has significantly improved during the pandemic owing to the soft market. Borrowers have to provide higher pricing and improved structure, making this an attractive time to invest in the asset class for higher total returns.
For these reasons, KJH believes that increasing exposure to the U.S. and European senior loan market can significantly benefit our clients’ portfolios.
Learn more about the KJH Senior Loan Fund:
We believe that it is important to provide our clients with absolute return mandates whose investment returns are less correlated to general market conditions and thrive irrespective of market volatility. Providing investment strategies that thrive across all economic and financial market conditions is paramount in preserving our clients’ emotional and financial capital during bear phases.
Effective August 1st, 2020, KJ Harrison has entered into a strategic alliance with Wellington Square Capital Partners of Toronto, Ontario. Wellington Square Capital Partners (WSQ) is a registered portfolio manager who manages, on a sub-advisory basis, our new KJH Senior Loan Fund. Investment managers Jeff Sujitno and Amar Dhanoya of WSQ have significant experience in managing senior and institutional loans; having printed positive net returns in the IA Clarington fund every year since its inception in November 2013. This is despite credit spreads widening materially in late 2015 and early 2016; notwithstanding, interest rates experiencing material volatility due to multiple rate hikes and, more recently, three interest rate cuts by the U.S. Federal Reserve.
KJH Senior Loan Fund
The KJH Senior Loan Fund will invest primarily in U.S. and European non-investment grade senior loans. The Fund will mitigate interest rate risk through the floating rate nature of the interest coupons attached to senior loans and focus on low volatility and capital preservation.
The Portfolio Managers will seek positive returns in all economic and market environments using disciplined risk management.
The KJH Senior Loan Fund will target annual unlevered, net returns of 4%-6% with long term volatility below 4%.
In order to provide capital preservation and maximum risk-adjusted return potential, the KJH Senior Loan Fund will employ the following strategies within the context of a sophisticated risk management framework:
- Invest in a portfolio of U.S. and/or European senior secured, floating rate loans;
- Generally, hedge currency risk;
- Generate investment returns primarily through contractual interest rate payments;
- Mitigate credit risk through diversification of holdings and avoiding commodity-related issuers/borrowers; and
- Opportunistically invest in private credit opportunities.
Our business practices are continually focused on achieving our clients’ long-term financial and investment objectives. By entering into a strategic alliance with Wellington Square to sub-manage our KJH Senior Loan Fund, we are able to provide our clients with access to the preeminent senior loan fund team in Canada.
Jeff has a 19-year investment track record managing portfolios for institutional and retail clients. He is responsible for portfolio construction and positioning and is responsible for private credit security selection.
Prior to founding Wellington Square, Jeff was Senior Vice President of Investments at IA Clarington where he was the lead Portfolio Manager of several funds and ETFs. Previously, Jeff was a Partner and Portfolio Manager at Norrep Funds where he created and led their senior loan investment business. Jeff began his investment career at McKenna Gale Capital joining as an Associate and becoming a Partner. At McKenna Gale, Jeff helped to manage funds on behalf of the largest institutional funds in Canada.
Jeff earned his HBA degree from the Ivey Business School at the University of Western Ontario. He is a CPA, CA and CIM®.
Amar has 16 years of leveraged finance experience across various investment management and investment banking functions. In his current role, Amar is responsible for portfolio construction and tradeable security selection.
Prior to Wellington Square Advisors, Amar was a Portfolio Manager at IA Clarington. Previously, Amar worked as an investment analyst at Katonah Debt Advisors and in leveraged finance portfolio management and loan capital markets at Société Générale and BNP Paribas.
Amar received his MBA from the Richard Ivey School of Business at the University of Western Ontario and a Bachelor of Science from Pepperdine University. He is a CFA Charterholder.