A must-read: The story of starting yield on loans

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      By John ReddingFloating-Rate Loan Portfolio Manager, Eaton Vance Management and Christopher RemingtonInstitutional Portfolio Manager, Eaton Vance Management

      Boston - Everyone knows the standard disclaimer, "past performance is no guarantee of future results." While certainly true, some guidance that could be an indicator of future results would be a lot more helpful.

      Fortunately for fixed income investors, there is one: starting yield. And — spoiler alert! — starting yield is a good indicator of why we see value in floating-rate corporate loans right now.

      Of course, starting yield doesn't guarantee anything. For example, bond prices will ebb and flow — say with credit conditions or "news" — on their path to eventual maturity. Yet a brief recap of bond fundamentals illustrates why starting yield is such an important metric.

      Bonds are debt issued at par value, sometimes called face, and earn a certain coupon income during the bond's life — if held to maturity, they are redeemed by the issuer at par. Under this simple scenario, the investor's total return would equal the stated coupon interest rate, because there has been no price change.


      With the basics in mind, the chart above tells a powerful, two-part story:

      Bond asset classes have experienced incredible returns over the last year. Yields collapsed as the US Federal Reserve rolled out their three rate cuts, helping power price gains that far outpaced coupon income, with most sectors returning near 9% (shown by the dots in the chart). For perspective, the Bloomberg Barclays US Aggregate Index had almost five years' worth of return (or yield) in the last year alone. Because of this, mathematically the future appears less bright. Just turn to each market's yield to maturity, which (as noted) is a fixed income investor's peek into the future (shown by the bars). What's on offer is 1.5% to 2% in many places.

      Yields look to favor credit markets — and in particular floating-rate corporate loans. As reflected in the data above, the starting yield on loans is among the highest available today. It's an area where a significant proportion of the yield is attributable to a meaningful credit spread. Also, the average loan market price is below par, while the other sectors trade at a premium, except for high-yield bonds. But loans not only yield more than high yield right now, they have two structural advantages over high yield: Loans are senior and secured in the capital structure, and have almost zero interest-rate duration — that is, no exposure to movements in rates. It's a rare day in the capital markets to be rewarded for less risk with higher return prospects. That loans were simply out of favor for much of last year as the Fed cut rates helps to explain much of this phenomenon.

      Bottom line: In our view, the story of starting yield on loans, compared with high yield and the other bond sectors, has a simple conclusion: Higher return prospects with less risk is an unusual offer — one that investors should consider carefully.