What is a senior bank loan?

A senior bank loan is a debt financing obligation that a bank or other financial institution issues to a business, which the business then repackages and sells to investors. The restructured debt commitment is made up of many loans. Legally, senior bank loans are superior to other debt obligations regarding the borrower’s assets.

In the case of bankruptcy, this debt will be paid back first, ahead of any other creditors, preferred shareholders, or ordinary stockholders, due to its seniority over all other claims against the borrower. Liens on the borrower’s assets often protect senior bank loans.

How a Senior Bank Loan Works

Loans are often utilized to provide a firm with the money it needs to meet its capital requirements and continue its regular operations. Collateral for the loans is often the company’s inventory, real estate, equipment, or property. Frequently, banks consolidate their many loans into a single debt obligation and offer it as a financial product for sale to investors. As a return on their investment, the investors subsequently get interest payments.

Since senior bank loans are the highest level of a business’s capital structure, senior loan holders usually get the money from the sale of the secured assets if the firm files for bankruptcy before any other kind of lender is reimbursed.

In the past, most companies with senior bank loans that ultimately had to file for bankruptcy could pay back all their creditors and investors. Senior bank loans are more secure since they have priority in the repayment schedule. However, they are still regarded as non-investment-grade assets because most corporate loans in the bundle are given to businesses that are not deemed investment-quality.

The interest rates for senior bank loans are usually variable and change based on benchmarks such as the London Interbank Offered Rate (LIBOR). For instance, the interest rate on the loan will be 8% if the bank’s rate is LIBOR + 5% and LIBOR is 3%. Interest on a senior bank loan may rise or fall regularly since lending rates often fluctuate monthly or quarterly. This rate also represents the yield that investors will get on their investments. As a safeguard against inflation, the variable rate feature of a senior bank loan shields investors from increasing short-term interest rates.

In the repayment structure, senior bank loans—generally divided into first and second lien categories—come first, then unsecured debt, and finally equity.

Particular Points to Remember

• Lenders have a higher credit risk when lending to businesses that take out senior bank loans since they often have worse credit ratings than their peers. This is not the case with most corporate bonds. Furthermore, senior bank loan values may be unpredictable and subject to frequent fluctuations. This was particularly true in the midst of the 2008 financial crisis.
• Senior bank loans usually yield more to the lender than investment-grade corporate bonds due to their inherent risk and volatility. Nonetheless, the loans return less than high-yield bonds, which have no such guarantee since the lenders are guaranteed to receive at least part of their money back before the company’s other creditors in the case of bankruptcy.
• Some investors who want a steady income and are prepared to take on extra risk and volatility may be wise to invest in mutual funds or exchange-traded funds (ETFs) that focus on senior bank loans. This is the reason:
• The variable rate on the loans means their returns will increase as the Federal Reserve hikes interest rates.
• Furthermore, comparatively cautious investors find senior bank loan funds appealing due to their risk-adjusted return over a three-to-five-year timeframe. Bonds sell below par when the loan funds perform poorly, raising the return for investors.

Additionally, investors might find comfort in the past comparatively low default rates of 3% for senior bank loan funds.

Conclusion

• A corporate loan bundled and sold to investors is a senior bank loan.
• Priority over all other financial commitments of a borrower is granted to senior bank loans.
• Senior bank loans are paid back before other creditors, preferred shareholders, and common stockholders when the borrower’s assets are liquidated in the case of bankruptcy.
• A lien on the borrower’s assets frequently serves to protect senior bank loans.
• Floating interest rates are typical for senior bank loans.
• Lenders that provide senior bank loans have historically been allowed to collect the whole loan amount if the borrower defaults.
• Senior bank loans often provide investors with substantial yield returns and inflation protection.