What is a Senior Bank Loan?
A senior bank loan is a debt financing obligation issued to a company or an individual by a bank or similar financial institution that holds legal claim to the borrower's assets above all other debt obligations. Because it is considered senior to all other claims against the borrower, in the event of a bankruptcy it will be the first loan to be repaid before any other creditors, preferred stockholders or common stockholders receive repayment. Senior bank loans are usually secured via a lien against the assets of the borrower.
How a Senior Bank Loan Works
Senior bank loans are often used to provide a business with cash to continue its daily operations. The loans are generally backed by the company's inventory, property, equipment or real estate. Because senior bank loans are at the top of a company’s capital structure, if the company files for bankruptcy, the secured property is typically sold and proceeds are distributed to senior loan holders before any other type of lenders are paid back. Historically, the majority of businesses with senior bank loans that ended up filing for bankruptcy were able to cover the loans entirely.
Senior bank loans have floating interest rates that fluctuate according to the London Interbank Offered Rate (LIBOR) or other common benchmark. For example, if a bank’s rate is LIBOR + 5%, and LIBOR is 3%, the loan's interest rate will be 8%. Because loan rates often change monthly or quarterly, interest on a senior bank loan may increase or decrease at regular intervals. This helps protect lenders from rising short-term interest rates that cause bond prices to decrease, as well as against inflation.
[Important: Senior bank loans should be the first debts to be repaid if the borrower goes bankrupt.]
Pros and Cons of a Senior Bank Loan
Businesses that take out senior bank loans often have lower credit ratings than their peers, so the credit risk to the lender is typically greater than it would be with most corporate bonds. What's more, the valuations of senior bank loans fluctuate often and may be volatile. This was especially true during the big financial crisis of 2008. Because of their inherent risk and volatility, senior bank loans typically pay the lender a higher yield than investment-grade corporate bonds. However, because the lenders are assured of getting at least some portion of their money back before the company's other creditors in the event of insolvency, the loans yield less than high-yield bonds, which carry no such promise.
Investing in mutual funds or ETFs that specialize in senior bank loans may make sense for some investors who are seeking regular income and who are willing to assume the additional risk and volatility. Because of the loans’ floating rate, when the Federal Reserve increases interest rates, the loans will deliver higher yields. In addition, senior bank loan funds typically have a risk-adjusted return over a three-to-five-year period that makes them attractive to fairly conservative investors. When the loan funds underperform, bonds sell at a discount to par, increasing an investor’s yield. Investors can also take some reassurance from the fact that senior bank loan funds’ average default rate historically is a relatively modest 3%.