Hawkish Fed cut signals support for senior loans

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      By Andrew Sveen, CFACo-Director of Floating-Rate Loans, Eaton Vance Management and Christopher RemingtonInstitutional Portfolio Manager, Eaton Vance Management

      Boston - As widely anticipated the U.S. Federal Reserve ("the Fed") cut its policy rate this week, marking its third such adjustment of the year. Positives abound for the floating-rate senior loan market. What?

      That's right, and here's why.

      All along the Fed has characterized this year's cuts as a "mid-cycle adjustment" and little more. This was underscored yet again in the Fed's statement accompanying its latest cut, with Chairman Jerome Powell adding that the Fed now sees a higher hurdle for additional rate cuts ahead. That's because its outlook has indeed improved.

      The Fed again maintained that it would "act as appropriate" to sustain the economic expansion, with the shift now being that the data would now need to deteriorate, and significantly, in order for additional cuts to be justified. That's quite different than the past two cuts, where the Fed indicated that the data needed to improve in order to not cut.

      By contrast, now, the Fed says that its current rate stance is "appropriate", and that economic performance would need to worsen meaningfully before further cuts would be considered.

      Our interpretation: No more rate cuts for now.

      Let's recap the positives for floating-rate senior loans:

      High yields: Despite a handful of year-to-date Fed cuts, the yield on loans remains high, in both an absolute as well as a relative sense. A yearlong stampede into duration-laden asset classes has pushed yields down in those areas. As an example, loans now outyield the "Agg" by almost 3-to-1. And in the "plus sectors", loans outyield the definitionally riskier high-yield bond market, and they outyield the emerging markets debt asset class, too. (See chart below). The irony: departing loan investors most frequently cited falling yields as their main concern, and they have experienced just that, elsewhere. Returning to loans will be a return to higher yields.


      Value Opportunity: One of the few segments in the bond world trading at a discount to par, loans are seemingly signaling value: The loan index enters November between $95-$96 on a dollar price basis. To underscore the opportunity, a discount of 4-5 points implies a 15-20% cumulative default rate, assuming a typical 75% recovery rate. Today's default rate is just over 1%, and the expectations are for similarly low levels in the year ahead. Even if a recession were to unfold somewhere down the road, consider that the GFC itself delivered fewer defaults than what's priced-in today. Does anyone think we have another GFC around the corner? We certainly don't. Anything less should present appreciation potential.

      Positive fundamental outlook: Earnings season has surprised to the upside, and the Fed notes its general comfort with the underlying growth picture. Unemployment is near generational lows, and stock prices are near all-time highs. Both defaults and the default outlook are low. There's plenty to watch for at the issuer level, and we are - each company we consider for our portfolios undergoes a robust fundamental research process. But en masse, the market is on solid footing.

      Bottom line: If the Fed is "on hold", performance in bond markets will largely come down to starting yield. And on that measure loans have a big head start.