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Senior Loans Make Sense as Interest Rates Rise

Jeff Brown

Many income-hungry investors have turned to senior loans to earn a tad more than they can on traditional bonds. But with the economy strong, interest rates rising and financial markets in a bit of a tizzy, how do they look today?

They look pretty good, according to many experts.

"Senior loans generate predictable, recurring fixed-income for investors, so they are a great option for older investors who are looking for passive retirement income," says Dan Vetter, president of M360 Advisors, an alternative investment management company in Ladera Ranch, California.

"We are especially drawn to the closed-end funds that invest in this space as they are currently trading at attractive valuations," says Greg Neer, partner at Relative Value Partners in Northbrook, Illinois.

[See: 7 Bond Funds to Buy as Rates Rise.]

Neer likes the fact that borrowers who run into trouble must repay senior loan debt before other types of debt, and notes that these securities pay more as interest rates rise.

Also called leveraged loans and bank loans, senior loans are loans from financial firms to companies with weak credit. Because that entails more risk than loans to top-quality borrowers, lenders charge higher interest rates, and pass the extra on to investors. Many senior loans pay 6 to 9 percent interest and the PowerShares Senior Loan exchange-traded fund (ticker: BKLN), which tracks a senior loan index, yields about 3.5 percent. The 10-year U.S. Treasury bond pays about 2.8 percent.

Unlike high-yield bonds and other generous but risky investments, senior loans, which are secured by borrower assets, stand at the front of the line of creditors if things go wrong for the borrower. If the firm has any money to meet obligations, senior lenders get paid first.

"In practice, in case of a bankruptcy, equity investors are in a first-loss position while senior debt holders are typically first in line to get paid," Vetter says.

Senior loan funds can be useful to young investors as well as retirees, he adds.

"While senior loans are considered a safer investment when compared to equity," he says, " they are also great for younger investors, who are traditionally more aggressive in their investing style, as senior loans tend to be uncorrelated with more traditional assets classes and therefore provide diversification benefits."

While a senior loan can disappoint if borrowers default, that may be less likely today than in recent years when the economy was weaker. In a strong economy even borrowers with tainted credit are more likely to keep up their loan payments.

Senior loans typically carry floating rates, so they will pay more if interest rates rise as most experts expect. This also insulates them from interest-rate risk, when prices of older bonds fall because newer ones are more generous.

[See: The 10 Best ETFs to Buy for 2018.]

Because a senior loan's health depends on a company that will march to its own beat, these loans offer another layer of diversification for investors mainly into stocks and bonds.

It's not a big universe, with only a few ETFs specializing in this area. Some experts prefer closed-end funds, or CEFs, which, unlike the more common open-ended funds, sell a limited number of shares rather than creating and dissolving shares as investor demand rises and falls. Closed-end funds can trade at a premium or discount to the net asset value -- the per-share value of the fund's assets, and many senior loan CEFs are trading at discounts today.

One such CEF, Nuveen Floating Rate Income (JFR) currently trades at a nearly 5 percent discount, reducing risk, while paying nearly 6.8 percent. (CEF payouts are called total distribution rate, which is the annualized recent payments divided by current share price.)

Vetter says many senior loan CEFs are open only to accredited investors -- those with high incomes or assets who are deemed sophisticated enough to take unusual risks. But there also open-ended funds that hold these loans, he adds.

"These funds provide daily liquidity and tend to be open to even the smallest investors," he says.

In addition, senior loans can have risks unfamiliar to ordinary investors, requiring a certain expertise in selecting a fund. Vetter says many of these loans are secured by the borrower's real estate.

"If the senior loan is secured by real estate, an investor should carefully evaluate the value and cash flow of the underlying real estate collateral," he says. "Typically, a loan-to-value of 65 percent to 70 percent, or less, is considered prudent."

The smaller the loan relative to the property value, the better the chance the property could be sold for enough to cover the debt.

Adham Sbeih, CEO of Socotra Capital, a real estate lending and investment firm in Sacramento, California, urges investors to assess the quality of any real estate used as collateral.

"Look for loans secured with investment properties, properties in states that allow non-judicial foreclosures, and loans with significant equity," he says.

[See: 8 Ways to Cash In on a Hot Housing Market.]

Senior loans offer investors a way to spread risk and a strategy to benefit from rising interest rates.

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