Before making any investment decision, whether it is in equity, fixed income or property, it’s important to consider whether you are adequately compensated for the risks you are taking. Understanding where your investment sits in the capital structure will help you recognise the potential downside that could result in permanent loss of capital.

Within a typical business, there are various financing securities used to fund existing operations and growth. Most companies will use a combination of both debt and equity. The debt may come in different forms, including senior secured loans and unsecured bonds, while equity typically comes as preference or ordinary shares. The exact combination of these instruments forms the company’s ‘capital structure’ and is usually designed to suit the underlying cash flows and assets of the business, as well as investor and management risk appetites.

The most fundamental aspect for debt investors in any capital structure are seniority and security in the capital structure which is reflected in the level of leverage and impacts the amount an investor should recover if a company fails to meet its financial obligations.

Capital structure seniority refers to where an instrument ranks in priority of payment. Creditors (debt holders) normally have a legal right to be paid both interest and principal in priority to shareholders. Among creditors, ‘senior’ creditors will be paid in priority to ‘junior’ creditors. Security refers to a creditor’s right to take a ‘mortgage’ or ‘lien’ over property and other assets of a company in a default scenario. Senior secured loans and bonds will typically have a first ranking claim over both the cash flow and assets of a borrower. Other forms of debt may by senior in payment but without any security (‘senior unsecured’) or be junior in both payment and security (‘subordinated’) but will still have a contractual right to both interest and principal. Payments of subordinated bonds can be subordinated at the discretion of management, and maybe deferred or even deferred and non-cumulative in the case of some hybrid securities.

The figure below outlines a typical capital structure of a company and leverage. As highlighted by the seniority to other securities, senior loans offer clients downside protection in the event of default.

Senior secured loans generally have a shorter tenor (five-eight years), compared to senior unsecured bonds (seven-plus years), subordinated debt (10-plus years), preference equity (perpetual and generally callable) and ordinary equity (perpetual).

Normally, debt investors are paid an additional credit spread for investing in securities with lower seniority and security. While equity can provide the highest potential total return, it also comes with higher risk of permanent capital loss. Equity holders share in the profit and also the losses of a company, and are paid after other obligations are fulfilled. Reflecting the higher risk, equity markets are significantly more volatile than debt markets.

For example, over the past 24 years, global equity markets have a volatility of 14.8 per cent per annum, compared with senior secured loans of just 5.35 per cent per annum.

Figure 1: Risk/return in a typical capital structure

Reflecting their seniority in the capital structure, senior secured loans typically fare better than other corporate debt instruments in the event of default. In a bull market, senior secured loans tend to perform well as underlying corporate fundamentals improve.

In a bear market, the first lien on assets provides a natural floor to loan prices. The table below outlines historical recovery rates for senior loans relative to other sub-investment grade credit instruments.

Apart from their position in the capital structure, other attributes of senior loans are diversity (with around 1,200 issuers) an active secondary market with on average $US45 billion traded every month and the fact that senior loans are floating in nature, which means they tend to perform well in a rising interest rate environment.

Source: JP Morgan. As at 30 Sep 2016

Given the benefits outlined above, primarily the seniority in the capital structure and the high levels of recovery from default, senior loans are now an institutionally accepted asset class, and held by many of the world’s leading pension and sovereign wealth funds.

They can reduce overall risk when added to portfolios of government bonds and equities. Investors can lower overall volatility and improve returns per unit of risk by allocating a portion of their portfolios to the asset class.

Richard Quin, managing director, Bentham Asset Management