High loan yields signal a buying opportunity (part three)

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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 - In two previous blogs, we outlined some of the reasons loans are the highest-yielding major fixed-income sector, as of September 30, 2019, eclipsing both high-yield bonds and emerging-markets debt. Loan yields are also high relative to their own historical returns.

      Investors who are considering investing in the loan market, or adding to a position, face the question of whether to do so through passive funds (typically ETFs) or through actively managed loan funds. In this final blog of the series, we outline Eaton Vance research that suggests a decisive advantage for the active approach.

      The chart below shows that since the first passive loan ETFs were introduced in 2011, the active loan funds in the Morningstar category have consistently outperformed, except for a brief stretch in 2014. In the 64 rolling three-month periods comprising the chart, beginning with the end of the first period in March 2014, the active fund universe outperformed by an annual average of 88 basis points (bps) during 95% of the periods measured.


      Sources: Eaton Vance Management and Morningstar, as of June 30, 2019. Total return is stated net of fund expenses, reflecting the asset-weighted averages of all funds in the Morningstar Bank Loan category in existence from 4/1/11 through 6/3019, weighted by beginning-of-period net assets. Performance reflects returns of 64 rolling 3-year periods ended from 3/31/14 through 6/30/19. The Morningstar Bank Loan category comprises U.S. issuers of floating-rate debt, typically secured by corporate assets. For mutual funds with multiple share classes, returns are those of "institutional" or similar (no-load/no 12b-1) share classes, which are most commonly used by financial advisors overseeing discretionary, fee-based client accounts. We exclude funds with incomplete data. Mutual fund returns reflect performance at NAV and ETF returns are based on market closing prices, in each case with fund distributions reinvested. Past performance is not a reliable indicator of future results; performance for different time periods may differ from the results shown.

      Assessing more recent performance trends, note that the degree of outperformance by active funds began to improve amid 2018's volatile fourth quarter.  For the rolling periods starting with December, active managers have outpaced ETFs by 118 bps - significantly more than the 88 bps long-term average. For a sector with a long-term total return of about 5%, measured by the S&P/LSTA Leverage Loan Index, a full percentage point advantage is substantial.

      We found several factors that help explain the advantage of active managers:

      • Active managers have outperformed their benchmarks.
      • The benchmarks used by active managers outperformed those used by passive ETFs, which are often concentrated subsets of the major indexes like the S&P/LSTA Leverage Loan Index.
      • Passive loan ETFs underperformed their own benchmarks, measured by both their NAV or market share price.

      These findings underscore the value that we see in the tools used by active managers such as credit research, a focus on issuer and sector valuation and selectivity. The increasing level of outperformance by managers since December highlights the fact that these tools become even more valuable as volatility increases.

      Given that we believe we are closer to the end of the credit cycle rather than the beginning, it follows that credit selectivity is becoming increasingly important. In a period of slower growth, the dispersion in performance in a below-investment-grade sector like the loan market tends to increase - this signals that the risks inherent in passive loan investing will grow, in our view.

      Bottom line: Since their inception in 2011, loan ETFs have yet to demonstrate a value proposition relative to active loan managers. The skills employed by active managers to achieve a higher return for investors are only likely to be more valuable in a late-cycle economy.