Senior Secured Loans give a false sense of security

These loans, which are very popular with investors because they promise good performance in phases of rising interest rates, nevertheless reveal a risk that is not taken into account.

Since the beginning of the year, the investment segment of Senior Secured Loans, or leveraged loans, has recorded inflows of approximately 12 billion dollars. Senior Secured Loans are securitized loans to highly indebted US companies, the coupons of which are linked to a variable short-term interest rate. In a rising interest rate environment, investors can therefore benefit from higher coupon payments and need not fear direct negative effects on performance.

Interest rate risk through the back door

However, the term “Secured Loans” is tricky. From a technical point of view, these are admittedly priority and guaranteed claims. But in fact, the balance sheet of debtors is very weak. In this context, the designation of leveraged loans (Leverage Loans) would be more relevant, even if it does not change the risks.

We believe that leveraged debt will be much more affected by the secondary effects of rising rates than global corporate bonds.

Due to their small size and weak balance sheets, leveraged debt issuers have little pricing power.

Significantly lower credit quality

Unlike creditworthy investment grade companies, issuers of leveraged debt generally do not have access to straight lines of credit and bank loans. Due to their low creditworthiness, refinancing with high yield bonds is often refused. Thus, in leveraged loans, the share of low B-rated issuers has risen from around 50% to 70% over the past ten years, while it has fallen from 50% to 40% in the segment. high yield.

Difficult macroeconomic context

Due to their small size and weak balance sheets, leveraged debt issuers have little pricing power. In the current context characterized by very high cost increases, this fact should have a negative impact on margins and therefore on profits. Added to this is the weakened economic growth which will also weigh on turnover. In addition, the sharp rise in interest rates will directly affect the income statement in the form of higher interest costs. For debtors, the negative combination of high inflation, weaker growth and high interest rates presents a significant challenge.

The weak point of the American economy?

According to our scenario analysis, the expected hike in US policy rates to 3% by mid-2023 could lead to a decline in the average interest coverage rate* from 2.5x to a low ratio of 1.4x. With a further 20% decline in earnings, the interest coverage ratio would continue to deteriorate towards 1.0x; from this threshold, a company could no longer make its interest payments from its operational activities. In this scenario, the ratings and defaults of leveraged debt issuers would likely increase significantly.

In the medium term, the variable interest rate structure of leveraged loans could prove to be the weak point of the American economy, with the consequent disadvantages for investors.

Evolution of the interest coverage rate according to interest and profits

Source: Zürcher Kantonalbank

* For interest coverage ratio, profit is compared to interest expense. It is thus possible to estimate the amount of profits that a company must devote to the payment of interest on its commitments. An interest coverage ratio of less than 1.0x means that the company can no longer pay interest on borrowings from its operational activities.

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