Traditionally, many people think of investing as placing savings or lump sums into an investment vehicle, such as a high-interest savings bank account, ISA, unit trust, bond or hedge fund. Other forms of investments include currency, property and artefacts. Investing in the loan market, such as in long or short-term loans, takes on a different meaning.
What does it mean to invest in the loan market?
Investing in the loan market means being part of a group who each take a part of what is called a syndicated loan, such as a loan leveraged by a private equity sponsor buying out a business’s equity. The loan is secured on the operating company’s assets and may therefore be referred to as a secured loan. If a default in long or short term lending occurs, lenders have a legal claim on the business’s assets.
Business owners may benefit from easier access to larger loan amounts, especially where credit history is weak. In the longer term, secured loans may be more cost-effective for expanding their operations.
How does investing in the loan market work?
In developing business, a company may take out a loan with a bank by signing a legally binding agreement. The loan rate applied is generally lower than loans issued within the bond market because the banks make up the difference in business financial service or product fees.
When buying out a business or business equity, a private equity sponsor may leverage a loan by paying between 30 to 70 per cent of the total price and covering the balance with a syndicated bank loan. The loan is underwritten by a large bank which then syndicates the loan out to other banks or institutional investors. These syndicated loans may comprise an amortising term loan and bullet maturity term loan with revolving credit facility.
Loan investors use credit analysis to assess the borrower’s credit rating. The loan duration, risk of default and post-default loss are considered in order to estimate secured loan investment viability, while profit is made from changes in the interest rate and terms. A short term loan for bad credit would be a riskier investment, as the customer would likely be taking out a high interest loan because they have a poor credit history. Secured loans are administered and settled through legal execution, rather than a clearing system, making them a less riskier investment option than unsecured bonds.
What are the benefits of investing in the loan market?
Investing in secured loans is an option available to institutional investors seeking benefits above higher-yield bonds. These benefits typically include:
- The borrowing company secures the loan with their operating assets.
- Higher rate of recovery if default occurs.
- A floating interest rate with added margin.
- Reduced price volatility within the secondary market.
- Private monthly management account access.
- Comprehensive protective covenants over borrowers.
- Loan investors may modify terms of agreement.
Secondary loan market prices now provide the potential for greater leverage for investors to gain higher profits. Being secured or a “secured asset class” means loan risk and volatility is lower, with added lender protection contributing to the potential for generating more predictable returns.