Five reasons investors should consider allocating to U.S. senior loans

U.S. senior loans, also known as broadly syndicated loans, floating rate loans or bank loans, have shot into prominence since the U.S. Federal Reserve (Fed) began hiking rates in 2022. Investors have taken notice of the attractive returns and remarkably low volatility provided by the asset class. While this market has grown to $1.4 trillion in size, it remains relatively misunderstood and under-owned by investors. We focus on five compelling reasons loans deserve a seat at the strategic asset allocation table for global investors.

What are U.S. senior loans?

U.S. senior loans are debt instruments issued by well known, below-investment grade companies typically with average EBITDAs over $500m.¹ These loans are structured and syndicated by banks to large groups of lenders including mutual funds, collateralized loan obligations (CLOs) and institutional investors. Notable issuers of loans include fast food giant Burger King and contact lens manufacturer Bausch & Lomb, as well as American Airlines, Formula One and Hilton.² Many issuers of U.S. senior loans are privately held companies, often backed by some of the largest private equity sponsors, including Blackstone, KKR and Carlyle.

U.S. senior loans have three main features that set them apart from other comparable asset classes. First, they are the most senior debt of a company, meaning loan holders have the highest priority of claims in the event of default.

Second, loans are secured by assets such as physical and intellectual capital, equipment, accounts receivable and inventories. Consequently, assets can be transferred to loan holders if a company defaults, generally leading to higher recovery rates than other below investment grade credit, as shown in the table below.

	Default rate	Recovery rate
U.S. high yield	3.0%	40.0%
U.S. senior loans	2.9%	63.5%

^{Data source: JP Morgan as of 30 Sep 2024. Data represents 25-year annual averages.}

Finally, U.S. senior loans are issued with a coupon that pays a predetermined spread above a variable rate, such as SOFR (Secured Overnight Financing Rate). Therefore, as rates rise, loan coupons reset and provide investors with higher income payments. It also means that loans have near-zero duration as these resets typically occur monthly or quarterly.

Why do U.S. senior loans make sense for investors?

1. U.S. senior loans offer a compelling risk-adjusted return

U.S. senior loans offer a high level of reward per unit of risk across several dimensions. When looked at from a yield per duration perspective, U.S. senior loans have one of the highest yields in fixed income coupled with very low sensitivity to interest rates (Figure 3). Investors may find similar levels of income in high yield bonds or emerging markets debt, both of which carry significantly longer duration.

When examined from a Sharpe ratio perspective, U.S. senior loans stand apart from fixed income peers (Figure 4). The combination of high coupons and relatively muted price changes at an aggregate level have enabled loans to generate high yield-like returns with investment grade-like volatility over the long term. As noted earlier, loans have near-zero duration which eliminates a major source of risk that besets bonds - interest rate risk. That said, U.S. senior loans are subject to credit risk, and therefore careful issuer selection is critical to success.

2. U.S. senior loans are resilient

The senior loan asset class has proven to be resilient through most market cycles, as the income from loans helps drive overall positive total returns even during periods of price volatility. The U.S. loan market has produced positive returns in 28 of the last 31 years (note in 2022, the asset class was down 1% while the broader bond market was down 13%). Additionally, contrary to widely held perceptions that loans only generate attractive returns in rising rate environments, U.S. senior loans have posted positive total returns in eight out of nine years when the Fed has cut rates (the only year loans were negative during those periods was 2008) according to Bloomberg data.

The Fed initiated its first rate cut of 50 bps in September 2024. Shortly following this, better than expected economic data was released, as well as U.S. election results leading to a change in party control. These data points led to further rate cuts being pared back substantially from prior expectations. The recent cuts (September and another 25bps in November) and economic outlook provide tailwinds for the loan asset class: as borrowing costs come down, we anticipate a rise in M&A activity supporting greater issuance, and companies that have good business but faced challenges in the higher rate environment should benefit from a lower cost of capital.

The loan asset class maintains a 3-year yield of over 8%, which remains one of the highest within the liquid fixed income space. Furthermore, post the 2024 U.S. election results, the Fed has signaled a base rate target in the range of 3.75 - 4.00%, which is comfortably higher than the 0% base rate we experienced post Global Financial Crisis and Covid-19. With a 10-year average spread of 400+ bps,³ loans would still yield over 7.5% making them an attractive diversifier in a fixed income allocation.

3. Diversification benefits of U.S. senior loans enhance their appeal

In addition to compelling risk-adjusted returns, U.S. senior loans bring diversification benefits to portfolios due to their lower correlations to other major asset classes. For instance, over the longterm, U.S. senior loans have a correlation of just 0.15 to high quality U.S. bonds and 0.60 to U.S. stocks. In comparison, U.S. high yield bonds have considerably higher correlations of 0.48 and 0.80 to high quality U.S. bonds and stocks, respectively.⁴ Figure 8 is a simplified illustration of the advantages this asset class can bring to a balanced portfolio. Adding a 10% allocation of U.S. senior loans to high quality bonds, increases portfolio returns while simultaneously reducing volatility.

4. Liquidity in senior loans provides flexibility for investors

One of the most important attributes of U.S. senior loans is liquidity. Loans trade actively on the secondary market. In the 12-month period ending May 2024, the average total monthly trading volume in the U.S. senior loan market was approximately $60 billion and cumulative volume was roughly $740 billion, representing over 50% of total market size. Funds that invest in loans can offer daily or weekly liquidity to underlying investors.

This feature is important for two main reasons. First, it facilitates the active management of portfolios by allowing managers to trade positions either for risk mitigation or return-seeking purposes. Second, it benefits end investors, as liquidity provides optionality to express their asset allocation and relative value views in real time instead of being locked up in multi-year investment vehicles.

5. U.S. senior loans have matured from niche to mainstream

At $1.4 trillion, U.S. senior loans can hardly be classified as niche. This rise has partly been fueled by robust issuance of CLOs, single securities backed by pools of debt, in this case, senior loans. CLOs currently make up two-thirds of the investor base in U.S. senior loans. These securities typically have a seven-to-ten-year life, making them long-term investors in the asset class. In addition, institutional investors comprise nearly 30% of the buyer base, bringing further stability to the loan market.

U.S. senior loans are now considerably larger than many other fixed income asset classes that are deemed mainstay in traditional portfolios, including emerging markets debt, U.S. high yield and European high yield.

Why Nuveen for U.S. senior loans?

For investors looking to access this exciting market, active management is key to success. U.S. senior loan indices are difficult to replicate, and ETFs that proxy broad loan market exposure tend to underperform. For instance, the largest such ETF has lagged peers 70% of the time in the past 10 years.⁵ Nuveen has invested in U.S. senior loans for more than 20 years through multiple market environments and credit cycles. Our leveraged finance team of over 40 investment professionals oversees more than $40 billion⁶ in leveraged finance assets, giving us the scale, resources and access that are necessary for success. Our investment approach emphasizes: 1) active management through daily re-underwriting of credits to identify relative value opportunities in buys and sells, 2) a preference for larger, more liquid loans that allow us to be more nimble than peers, and 3) greater selectivity in the new issue market, seeking to avoid overpriced loans and weaker business models. An unwavering commitment to these tenets has enabled us to deliver compelling risk-adjusted returns for nearly a quarter of a century in the U.S. senior loan asset class.

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