Bank loan

Definition of senior bank loan

What is a senior bank loan?

A senior bank loan is a debt financing bond issued to a business by a bank or similar financial institution, then repackaged and sold to investors. The repackaged debt obligation consists of several loans. Senior bank loans hold a legal right to the borrower’s assets before any other debt obligation.

Since it is considered to have priority over all other claims against the borrower, in the event of bankruptcy it will be the first loan to be repaid before any other creditor, preferred shareholder or ordinary shareholder receives repayment. Senior bank loans are generally secured by a lien on the borrower’s assets.

Key points to remember

  • A senior bank loan is a business loan repackaged into a set of business loans that are sold to investors.
  • Senior bank loans take priority over all other debt obligations of a borrower.
  • In bankruptcy, senior bank loans are paid before other creditors, preferred shareholders and common shareholders, when the borrower’s assets are sold.
  • Senior bank loans are generally secured by a lien on the borrower’s assets.
  • Senior bank loans most often have variable interest rates.
  • Historically, lenders who issue senior bank loans have been able to recover the entire loan when the borrower is in default.
  • Senior bank loans generally offer high returns to investors and protection against inflation

How a senior bank loan works

Loans are often used to provide a business with liquidity to carry on with day-to-day operations or any other capital needs it may have. Loans are generally secured by the company’s inventory, property, equipment or real estate as collateral. Banks often take the multiple loans they make, repackage them into a single debt instrument, and sell them to investors as a financial product. Investors then receive the interest payments as a return on their investment.

Since senior bank loans are at the top of a company’s capital structure, if the company files for bankruptcy, the secured assets are usually sold and the proceeds are distributed to senior loan holders before any other type of lender will be repaid.

Historically, the majority of companies with senior bank loans that ended up going bankrupt have been able to fully cover the loans, meaning the lenders / investors have been paid back. Since senior bank loans take priority in the repayment structure, they are relatively safe, although they are still considered to be low-grade assets, as most of the time the business loans in the package are granted to inferior companies.

Senior bank loans typically have floating interest rates that fluctuate based on the London Interbank Offered Rate (LIBOR) or other common benchmarks. For example, if a bank’s rate is LIBOR + 5% and LIBOR is 3%, the loan interest rate will be 8%. Since loan rates often change monthly or quarterly, interest on a senior bank loan can go up or down at regular intervals. This rate is also the return that investors will make on their investment. The variable rate aspect of a senior bank loan offers investors protection against rising interest rates in the short term, as well as protection against inflation.

In the repayment structure, after senior bank loans, which are generally ranked first and second lien, come unsecured debt followed by equity.

Special considerations

Companies that take out senior bank loans often have lower credit ratings than their peers, so the credit risk to the lender is usually higher than it would be with most corporate bonds. . In addition, senior bank loan valuations fluctuate often and can be volatile. This was especially true during the 2008 financial crisis.

Due to their inherent risk and volatility, senior bank loans generally offer the lender a higher return than high quality corporate bonds. However, since lenders are guaranteed to get at least some of their money back before the company’s other creditors in insolvency, loans pay less than high-yield bonds, which do not carry such a promise.

Investing in mutual funds or exchange-traded funds (ETFs) that specialize in senior bank lending may be worthwhile for some investors who seek regular income and are prepared to take on the additional risk and volatility. Here’s why:

  • Because of the variable rate of loans, when the Federal Reserve increases interest rates, the loans will offer higher returns.
  • Additionally, senior bank loan funds typically have a risk-adjusted return over a three to five year period, making them attractive to fairly conservative investors. When loan funds underperform, bonds sell at a discount to par, increasing investor returns.

Investors can also be reassured that the average default rate for senior bank loan funds has historically been relatively modest at 3%.