Senior Bank Loan

Senior Bank Loan: Definition, How It Works, Rates & Risks

What is a senior bank loan?

A senior bank loan is a corporate loan made by a bank or similar financial institution, often secured by the borrower’s assets and legally senior to other claims on those assets. Banks commonly repackage multiple such loans into a single debt obligation and sell it to investors. Because senior loans hold priority in the capital structure, they are paid before unsecured creditors, preferred shareholders, and common shareholders if the borrower defaults or files for bankruptcy.

Key takeaways

• Senior bank loans are secured corporate loans that take priority over other debt and equity claims.
• They are typically repackaged and sold to investors.
• Senior loans usually carry floating interest rates tied to benchmarks (e.g., LIBOR or other common references).
• In bankruptcy, senior loan holders are paid before other creditors and equity holders.
• These loans often target non-investment-grade companies, so they offer higher yields but still tend to recover substantial amounts in defaults.
• Average historical default rates for senior loan funds have been relatively modest (around 3%).

How senior bank loans work

• Banks make loans to companies for working capital, capital expenditures, or other needs. Loans are commonly secured by collateral such as inventory, equipment, property, or real estate.
• Multiple loans can be bundled and repackaged for sale to investors. Investors receive interest payments as their return.
• Because of their priority claim and security, proceeds from sold assets in a bankruptcy are typically used first to repay senior loan holders.
• Senior loans are often classified as first-lien or second-lien debt. After senior secured debt comes unsecured debt and then equity in the repayment hierarchy.

Interest rates and inflation protection

• Senior bank loans generally carry floating interest rates that reset periodically (monthly, quarterly, etc.). Rates are often quoted as a spread over a benchmark (for example, LIBOR + 5%).
• The floating-rate feature helps protect investors from rising short-term interest rates and inflation, since coupon payments adjust with the benchmark.

Risks and special considerations

• Credit risk: Borrowers with senior loans are frequently lower-rated than investment-grade firms, increasing credit risk.
• Valuation volatility: Senior loan prices can be volatile and sensitive to market stress, as seen during past financial crises.
• Relative yield: Senior loans generally offer higher yields than investment-grade corporate bonds because of greater credit risk, but typically yield less than unsecured high-yield bonds because of their priority claim and collateral.
• Recovery history: Historically, many senior loans in bankruptcies have been largely or fully recovered by lenders, which reduces but does not eliminate risk.

Investing in senior bank loans

• Investors commonly access senior loans via mutual funds or exchange-traded funds (ETFs) that specialize in this asset class.
• Reasons investors consider senior loan funds:
• Floating-rate income that can rise with short-term rate increases.
• Potentially attractive risk-adjusted returns over three- to five-year horizons.
• Historically modest average default rates for loan funds.
• However, investors should accept higher credit risk and possible price volatility, especially during economic downturns.

Conclusion

Senior bank loans combine secured, high-priority claims on a borrower’s assets with floating-rate coupons. They offer investors protection from rising short-term rates and higher yields than investment-grade debt, at the cost of greater credit risk and price volatility. Access is typically achieved through funds that can provide diversified exposure to the underlying loan pool.