This is a market that outweighs all bonds issued by U.S. borrowers with speculative-grade ratings (BB+ or Ba1 and below), totaling at nearly $1.6 trillion.

The market in question is senior loans — syndicated loans extended by several banks, mostly to US companies that also carry ratings below the investment-grade threshold.

Strong growth in the U.S. and European senior loan markets. (Graph: Nuveen)

However, the banks do not keep these loans on their own balance sheets. Instead, they syndicate them, selling portions to collateralized loan obligation (CLOs) vehicles, which pool the loans and issue notes backed by them. Senior loans are also sold directly, without securitization, to specialized funds and institutional investors.

Scott Caraher has been with US asset manager Nuveen for more than 24 years and played a key role in building its senior loans business. Today, he is Head of Leveraged Finance Portfolio Management.

Part of fixed income, but without interest-rate risk

Nuveen, a subsidiary of the US teachers’ pension fund Teachers Insurance and Annuity Association (TIAA), also has a presence in Switzerland and recently acquired British asset manager Schroders, which was announced in February and completed a few weeks ago. Schroders employs around 300 people in Switzerland, whereas Nuveen only has around five people in the local sales team. finews met with Caraher at the firm’s Zurich office. Michele Perone, head of Nuveen’s Wealth Switzerland and Southern Europe business, also took part in the discussion.

Although senior loans have floating interest rates and therefore do not carry substantial interest-rate risk, they are part of a portfolio’s fixed-income allocation. Swiss investors are generally considered quality-conscious in this regard.

What is the case for investing in senior loans with an average single-B rating?

"It is one of the few areas that offers a relatively stable and substantial yield premium without interest-rate risk."

“Three years ago, we launched a senior loans fund for European investors as well. With Scott’s help, we have since won several institutional investors and family offices as clients,” Perone explains, immediately adding the main selling point: “It is one of the few areas in the fixed-income universe that offers a relatively stable and substantial yield premium without interest-rate risk.” In US dollar terms, the target return is around 7.5%.

Caraher does not mince words. “Managing credit risk is critical to success. We have over 15 sector analysts who continuously analyze sector- and company-specific risks so that we have as few defaults as possible.” Exchanging insights with the firm’s other fixed-income specialists is also important.

For Caraher, active management is the only option in his asset class. “For example, in the first quarter we deliberately reduced our exposure to the software sector significantly.” Unlike in equities, passive senior loan vehicles have regularly underperformed actively managed products.

"Managing credit risk is critical to success."

His team knows the issuer landscape inside and out. They manage approximately $30 billion in senior loans across their funds and CLOs. Their flagship product, a large US fund, is close to $2.5 billion. “We speak directly with companies all the time to gain an even sharper and more complete picture of their businesses and, ultimately, their credit quality. These conversations are a central part of our investment process.”

In addition to selecting the right investments and closely monitoring positions, diversification is also essential for Caraher. The US fund holds more than 200 positions. On average, a company accounts for 0.5% to 0.7% of the fund, while the largest position ranges from 1% to 1.5%.

“Our fund offers daily pricing and liquidity, and the loan market has a daily trading volume of around $4 billion. In the current environment in particular, this daily liquidity is not insignificant for some investors,” the senior loans specialist notes. “Our investor base is much broader and more diversified than that of private credit. Our investors generally understand the characteristics of senior loans very well.”

"In the current environment in particular, daily liquidity is not insignificant for some investors.”

But is this not a somewhat unfavorable time to promote senior loans or enter the asset class?

First, there are signs that the long-benign credit cycle may be turning, which could reduce corporate profits and, in turn, borrowers’ credit quality. Second, US Treasuries now yield more than 5% - the highest level in nearly 20 years - and carry virtually no credit risk.

For Caraher, it is not about timing. “The performance of senior loans is relatively stable. In recent years, the market has returned an average of 6.5%. By contrast, anyone who invested in Treasuries at the beginning of the year is in negative territory.” He also points to an important characteristic of senior loans: “They dampen volatility in a fixed-income portfolio when interest rates rise.”

An exceptionally attractive risk-return profile in the fixed-income universe. (Graph: Nuveen)

For years, Caraher has been telling investors that they are underinvested in his asset class. “Loans are a very powerful portfolio tool, regardless of the market environment. They reduce duration and increase yield.” Senior loans should therefore be viewed as a strategic component of asset allocation.

Moderate correlation to US equities

Speaking of asset allocation, interest-bearing securities issued by speculative-grade companies often have a substantial correlation with equities. Over the long term, the correlation of US loans to US equities is 0.59 and therefore moderate, Caraher notes. Over the past 10 years, the S&P US equity index posted losses in nine quarters, compared with only five for senior loans. The correlation with the broad bond market (Bloomberg Global Aggregate Bond Index) was just 0.23 over the same period.

The specialist also highlights the economic significance. “Senior loans give investors access to the full breadth of the economy, including listed and privately held companies across all sectors.”