What is a Senior Bank Loan
A senior bank loan is a debt financing obligation issued by a bank or similar financial institution to a company or individual that holds legal claim to the borrower's assets above all other debt obligations. The loan is considered senior to all other claims against the borrower, which means that in the event of a bankruptcy the senior bank loan is the first to be repaid before all other interested parties receive repayment. Because senior bank loans are usually secured via a lien against the assets of the borrower, if the borrower should enter a state of bankruptcy in the future, the assets used to secure the senior bank loan must be used to repay the senior bank loan before other creditors, preferred stockholders or common stockholders receive any payment.
BREAKING DOWN Senior Bank Loan
Senior bank loans help businesses continue daily operations. The loans are typically backed by company inventory, property, equipment or real estate. Because senior bank loans are at the top of a company’s capital structure, the secured property is typically sold and proceeds are distributed to loan holders before other lenders are paid. Historically, the majority of businesses with senior bank loans that ended up filing for bankruptcy were able to cover the loans entirely.
Pros and Cons of Senior Bank Loans
Senior bank loans have floating rates that fluctuate according to the London Interbank Offered Rate (LIBOR) or other benchmark. For example, a bank’s rate is LIBOR + 5%, and LIBOR is 4%. Therefore, the loan yield is 9%. Because loan rates often change monthly or quarterly, interest on the loan may increase or decrease at regular intervals. This helps protect investors from rising short-term interest rates that make bond prices decrease, as well as against inflation.
Because businesses receiving senior bank loans often have lower credit ratings, credit risk is typically greater than with other types of bonds. For this reason, valuations of senior bank loans fluctuate often and may be volatile. This was especially true during the big bank crisis of 2008.
Because of senior bank loans’ volatility, they typically have higher yields than investment-grade corporate bonds. However, because the lenders are paid back before other creditors in case of insolvency, the loans yield less than high yield bonds.
Investing in Senior Bank Loan Funds
Investing in senior bank loan funds may be beneficial for investors seeking regular income. Typical loan funds yield 5% to 6%. Because of the loans’ floating rate, when the Federal Reserve increases interest rates, loans have greater yields. Also, senior bank loan funds typically have a risk-adjusted return over a three-to-five-year period that makes them attractive to conservative investors. When the loan funds underperform, bonds sell at a discount to par, increasing an investor’s yield. In addition, the loan funds’ average default rate historically is 3%, making the funds even more attractive to investors.