What Is a Senior Bank Loan?
Let me explain what a senior bank loan is: it's a debt financing obligation that a bank or similar institution issues to a company, then repackages and sells to investors like you. This repackaged obligation includes multiple loans, and these senior bank loans have a legal claim on the borrower's assets that ranks above all other debt obligations.
Since they're senior to other claims, if the borrower goes bankrupt, these loans get repaid first from the asset sales before any other creditors, preferred stockholders, or common stockholders see a dime. Typically, they're secured by a lien on the borrower's assets.
Key Takeaways
- A senior bank loan is a corporate loan repackaged into a bundle of corporate loans sold to investors.
- Senior bank loans take priority over all other debt obligations of a borrower.
- In bankruptcy, senior bank loans receive payment before other creditors, preferred stockholders, and common stockholders when borrower assets are sold.
- Senior bank loans are typically secured via a lien against the borrower's assets.
- Senior bank loans most often come with floating interest rates.
- Historically, lenders issuing senior bank loans have recovered the full loan amount in borrower defaults.
- Senior bank loans typically provide high-yield returns for investors and protection against inflation.
How a Senior Bank Loan Works
You know how loans help businesses with cash for operations or other needs? They're often backed by the company's inventory, property, equipment, or real estate as collateral. Banks take these multiple loans, bundle them into one debt obligation, and sell them to investors. As an investor, you then get the interest payments as your return.
Because senior bank loans sit at the top of a company's capital structure, in bankruptcy, the secured assets get sold, and proceeds go to senior loan holders first before other lenders.
In history, most businesses with these loans that filed for bankruptcy covered them fully, so investors got paid back. This precedence makes them relatively safe, but they're still non-investment grade since the loans often go to non-investment grade companies.
These loans usually have floating interest rates based on LIBOR or similar benchmarks. For instance, if the rate is LIBOR + 5% and LIBOR is 3%, you get 8%. Rates can change monthly or quarterly, so your interest might go up or down. This floating rate protects you against rising short-term rates and inflation.
In the repayment order, after senior bank loans (first and second lien), comes unsecured debt, then equity.
Special Considerations
Businesses taking out senior bank loans often have lower credit ratings, so the credit risk is higher than with most corporate bonds. Valuations can fluctuate and be volatile, as seen in the 2008 financial crisis.
Due to this risk and volatility, they pay higher yields than investment-grade bonds. But since lenders get some money back first in insolvency, they yield less than high-yield bonds without that assurance.
If you're looking for regular income and can handle the risk, consider investing in mutual funds or ETFs focused on senior bank loans. Here's why: their floating rates mean higher yields when the Fed raises rates. They often have good risk-adjusted returns over three to five years, appealing to conservative investors. When underperforming, bonds sell at discounts, boosting yields.
You can take some comfort in the historical average default rate of about 3% for these loan funds.
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