Senior Secured Debt Can Be Lucrative for Investors

Those holding senior secured debt are the first ones to be paid if a company fails. By Christine Giordano

June 13, 2016, at 9:00 a.m.

Senior Secured Debt Can Be Lucrative

Senior secured debt has seniority over all other debts, which means it is first to be reimbursed.

The year was 2009 and General Motors Co. (ticker: GM) had just declared bankruptcy. Financial carnage ensued.

GM stock plummeted to zero value. People who owned it lost everything. Those invested in GM common bonds tried to collect something, and grabbed at pennies – about 20 cents on the dollar. Even when the company resurrected, those with old stock couldn’t trade it in for new stock.

Only one group of people was able to collect close to 100 percent of the money they had invested in the company.

“The senior secured debt holders got 100 percent of their money back. They were the first ones in line,” says Michael Brady, president of Generosity Wealth Management in Boulder, Colorado.

Senior secured debt holders are invested in debt that is tethered and secured to something solid as collateral – like the very buildings that houses a company, or accounts receivable. And because it is considered “senior” debt, it has seniority over all other debts, which means it is first to be reimbursed.

“That debt has to be settled before anything else can be settled,” says John Foard III, senior wealth advisor at Hobart Financial Group in Charlotte, North Carolina. “It (GM) was a great example of how these notes are designed to work.”

There are a few ways to add senior secured debt, also known as bank loans or leveraged loans, to your portfolio. They are available as traded stock, exchange- traded funds, mutual funds or a non-traded space, Foard says. Senior secured debt adds diversity to a portfolio, and during periods of rising interest rates is generally more stable than traditional fixed-income investments.

“The generated yield looks somewhere between 5 and 7 percent. You can’t get that kind of a yield in bonds right now,” Foard says.

You can buy the stock, considered the liquid version – or the illiquid version, which you usually have to hang on to for five to eight years.

There are benefits to each. The liquid, or stock, version can be sold fairly quickly, but usually provides a lower yield, around 4 to 6 percent compared to 6 to 8 percent for illiquid version, or non-traded note packages. Illiquid versions eliminate some of the panic sells that can happen in times of concern or panic, Brady says.

Also, illiquid debt in the non-traded space pays a higher dividend because taxes are paid later, Foard says, which means they have less revenue when they’re taxed.

But make sure that the companies that are being lent to in these programs are being heavily vetted, Foard says. “It’s going to require some homework on the investors’ part or relying on a solid advisory firm.”

Although the yield is typically higher, illiquid senior secured debt is an investment for accredited investors who can stay in for at least five years. “There are penalties to get out of it early, and there’s no guarantee that they will buy your shares back, either,” Foard says.

Investors should also limit their exposure. “During retirement, if you need to sell something off, you don’t want to be subjected to fees and penalties and get stuck,” Foard says.

Make sure it’s bundled favorably. Senior secured debts are generally used by companies to finance expansions or acquisitions, so investors need to make sure the bundled deal is favorable – for example, that it’s a debt of $20 million for a company worth $100 million, instead of a debt of, say, $80 million.

“From a leverage standpoint, you want to make sure you’re working with the lending company that’s going to be looking out in your best interest and only lending up to somewhere between 30 and 50 percent of that size of the company,” Foard says. “Because if you had to liquidate to sell off their assets to get your money back, and you had to do it on a fire sale, you want to still be able to at least get 100 percent of your money back at a minimum, if you can.”

Investors in the space should hold several companies’ debt. “My recommendation to clients is to buy a packaged program where you’ve got a couple of hundred different companies that are being lent money to at a given time, with average of three-year terms to balloon that payment back to that company, and if one or two of those go bad, you know, you’re not wrecking the entire portfolio,” Foard says. “So, it’s diversification of the risk by using a packaged program.”

Investors looking to stake a position can best choose a large lending firm like Blackstone Group (BX) to vet the companies offering debt.

But how do individual investors get access to Blackstone, a company that works primarily with institutions and endowments? One way is to work with an affiliated group, says William Saunders, a wealth manager at Richmond, Virginia- based Equity Concepts.

“One of the best groups in that space is Franklin Square Capital Partners. You can work with one of the advisors that has a relationship with Blackstone and get access,” Saunders says. “Another big name you hear quite a bit in this space is The Carlyle Group.”

CION Investment Corp. and two mutual funds – Oppenheimer Senior Floating Rate Fund (OOSAX) and Easton Vance Floating Rate & High Income Fund (EVFHX) – are other players in the senior corporate debt space, Brady says.

Diversify your companies as well as your ratings. “You wouldn’t want to only have 20 different companies. Most mutual funds or business development companies – a closed-end investment company that invests in small and mid- sized businesses – might have 1 to 3 percent of any one company.

“Keep to a ratio of mostly A-ratings, with only up to 20 percent B ratings, since B may be more aggressive, but also considered “junk” ratings with a higher likelihood of not repaying the debt, Brady says.

Determine your risk level. “The downside to senior securities is that there are some liquidity issues; the money is tied up longer than traditional fixed income, you can’t just sell it,” Saunders says. “You’re giving a loan to a company, and they can’t pay the money back immediately; it is not like a traditional bond that trades in the open market. It is a private security – you’ve lent money to someone.”

Always keep in mind that you’re buying debt, which can be risky, and relegate it to a small percentage of your portfolio.

“Compared to a stock, it’s not volatile at all,” Brady says. “Compared to a money market or a CD, it’s super volatile.”

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