High loan yields signal a buying opportunity

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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 - Here is a puzzle for the day:

      • On the one hand, the U.S. Federal Reserve recently lowered rates by 25 basis points (bps) and appears to be poised to cut again in the near future by a similar amount.
      • On the other hand, floating-rate loans - which by definition have interest payments that move in tandem with short-term rates - are the highest-yielding major fixed-income sector, as of August 31, 2019.

      This is the first in a short series of blogs in which we will explain the reasons behind this seeming contradiction, and why we believe loans currently offer an attractive buying opportunity.

      Starting yields historically have been reliable guides to future returns. By that measure, floating-rate loans should draw attention, both in comparison with other fixed-income sectors and relative to their own history. For example, the chart below shows how the yield on loans has recently moved higher than high-yield bonds, reversing their typical relationship. As of August 31, 2019, the yield on loans was 6.7%, based on the S&P/LSTA Leveraged Loan Index, compared with the 5.9% yield on the ICE/BofAML US High Yield Index. By way of comparison, the benchmark Bloomberg Barclays U.S. Aggregate Index is yielding 2.1%.

      Loans are the highest-yielding fixed-income class 


      Sources: Bloomberg LLC, St. Louis Federal Reserve Bank, as of August 31, 2019.

      Loan yields are also higher than those of emerging-markets debt - again reversing the typical relationship. Keep in mind that with loans, there aren't the currency or political risks of emerging markets debt, and relative to high-yield, loans are senior in the capital structure and secured. The yield on loans today is also historically high, relative to their long-term average total return - about 6.7% to 4.9%, or a 180-bps advantage.

      What's behind the rise in loan yields? A key factor is the inverted yield curve. Loans are generally priced off of 1-month Libor, which yielded 2.09% on August 31, 2019, while high-yield bonds are priced off comparable-maturity U.S. Treasury bonds. As of August 31, 2019, both the 10-year U.S. Treasury (yielding 1.50%) and the 5-year U.S. Treasury (yielding 1.39%) had yields lower than Libor. So in the unusual environment of an inverted yield curve, loans were being priced off of a higher-yielding benchmark than high-yield bonds - that's a big factor in the atypical loan/bond spread.

      Negative retail sentiment is also keeping yields higher than normal. Loans have experienced large net outflows from the retail sector - more than $20 billion this year, following $18 billion in December 2018, which puts upward pressure on loan yields. The net outflows have helped push the market price of the S&P/LSTA Leveraged Loan Index to 96, while other fixed-income sectors are trading above par, or just under.

      Most of this negative sentiment is predicated on the common belief that floating-rate loans must underperform in a falling-rate environment - a misconception we'll address in a subsequent blog. Retail loan investors represent approximately 10% of the market, but at times (like these) can have an inordinate impact on loan prices.

      Bottom line: Investors who equate falling rates and Fed accommodative policy with subpar loan performance should take a closer look at today's yields. It's also instructive to review loans' history in falling-rate environments - something we'll do in the next blog.