Risk / Return Profile
Much of the reason that leveraged loans are viewed as an attractive asset class can be attributed to the compelling risk / return opportunity offered. Historically, loans have proven to be significantly less volatile than most asset classes, with all other things being equal. The low volatility nature of loans can be traced back to three primary factors:
- Floating Rate: Loans are floating rate securities that offer a spread above the London Interbank Offered Rate (LIBOR); this LIBOR rate normally resets every one to six months, virtually eliminating interest rate risk.
- Collateral Protection: Loans are typically the senior most obligations in an issuer’s capital structure, with a first priority lien on all of the borrower’s assets. In many cases, this top position in the capital structure leads to the loan being over collateralized; in other words, the borrower has more assets than loans outstanding. Due to this collateral protection, loans are the last security to experience volatility – and are affected the least – in the event an issuer’s financial condition deteriorates.
- Pre-payable: Loans are pre-payable at any time and in most cases there are little to no penalties for doing so. Loans tend to repay ahead of schedule, particularly if the financial position of the issuer is improving. This scenario creates a shorter duration which further tempers volatility.