Post rate cut: The case of floating-rate loans remains intact

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The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness.

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      By Craig P. RussCo-Director of Floating-Rate Loans, Eaton Vance Management and Andrew Sveen, CFACo-Director of Floating-Rate Loans, Eaton Vance Management

      Boston - At the start of the year the investment thesis for the senior loan asset largely came down to these factors:

      • Interest rates are low and therefore so are expected returns in much of fixed income. By contrast, loan yields and expected returns are higher based on the S&P/LSTA Leveraged Loan Index compared to the other major fixed-income indexes.
      • Volatility was uncharacteristically low, in both stocks and bonds. Loans have historically shown to be a dampener when volatility rears its head.

      Enter coronavirus and now an emergency rate cut by the Federal Reserve. What changes?

      • Bond rates are still low (indeed, they are lower). And two months into the year, loan yields and expected returns are now even higher.
      • Volatility abounds. Historically, loans have helped to soften the blow in client accounts, just the latest in a long history of these examples.

      In short, the case for the asset class remains well intact, if not underscored. At the same time, there is plenty to think about - and we are - and we know clients are anxious at moments like these. So here we share some thoughts on some of the most commonly asked questions this week:

      Coronavirus - what does it mean for loans?

      We blogged our initial reaction last week, and it still holds: Our assessment of the loan market hasn't changed as stocks have swooned amid worsening virus headlines. To be sure, we've been tracking developments surrounding the virus closely. At the same time, we remain committed to the core tenets of our investment philosophy and the strict adherence of our portfolio construction process. These have endured the test of time - we mark 31 years in this asset class in 2020 - in no small part because a dual focus on bottom-up credit fundamentals and risk management has historically delivered for our clients.

      We don't have a detailed "take" on all things coronavirus and what it all "means." Frankly, we raise an eyebrow at anyone who does. Much of the data is suspect. The speed and reach of the virus' ultimate spread are simply unknowable, and therefore its potential impact on global economic growth and financial markets are unknowable as well. Though the study of past epidemics is no guarantee of the future of this particular one, history seems to suggest that little permanent scarring occurred to financial markets following those such as SARS, MERS, bird flu, swine flu and many others - and most certainly not in the senior corporate loan market where we spend our days.

      What's transpired in loans as capital markets have corrected?

      Loans have held up remarkably well though they've not been completely immune. The asset class remains in a supply-shortage mode and accounts have had cash to deploy. This has helped keep the technical condition of the market relatively firm. At the same time, the ongoing fear trade that has spread across capital markets at large has had spillover effects on the loan market. To be sure the magnitude of the moves has paled in comparison with the downside in stocks, high-yield bonds and other asset classes. But loan prices are certainly softer today than two weeks ago. Many have asked about "specific" areas of exposure most directly impacted by all of this. For example, exposure to casinos, airlines and hotels. We're also looking at auto companies, and energy-related credits remain in focus as well. While all of these areas are small segments of the market, what's important to note is that the market selloff has been much more "meta" in nature, impacting not just these areas but every individual sector across the market.

      The average price of the S&P/LSTA leveraged Loan Index opened this morning at $94.9, a level unseen since the volatile days of December 2018. As with other short-term downdrafts in the loan market's past - August of 2011 (Bernanke's zero interest rate policy rollout), February of 2016 (final capitulation of the energy selloff) as examples - clients over the last year often lamented about "missing the window" to add to this asset class on the cheaper side of history. In our view, the market is signaling value today. Prices may move lower before they rally - trying to guess the timing is a fool's errand in our view - but history has shown that a dollar put at risk at today's levels has been consistently rewarded.

      FRL Fed

      How does the Fed's rate cut factor into things?

      To state the obvious, neither cutting interest rates nor expanding its balance sheet does anything to directly help with the development of a vaccine or the containment of the virus. This feels like the Fed "pushing on a string", though we leave it to the economists and our macro friends to debate this. With rates already so low, isn't the Fed using its easing bullets prematurely? Look at growth, the unemployment rate, corporate performance, asset values (at least until recently). At the same time, there are some likely positives of a pre-emptive move. It signals support and a willingness to act, and more broadly the G7 appear to be coordinated in a concerted attempt to keep financial conditions loose. It's hard to see how this could serve as anything but a supportive backdrop for corporate credit.

      More directly, a lower policy rate from the Fed portends lower LIBOR, which in turn points to lower loan yields, all else equal. Higher new-issue spreads can (and often do) provide a degree of offset, and today's discounted loan prices "pay" for the cut and a good amount more. All in all, the most basic and important lesson in fixed income is that "starting yield matters". On that measure we have comfort in the forward return picture for this asset class.

      Bottom line: During times like these, we think maintaining a well-reasoned asset allocation may serve investors well. We see loans as playing important roles in client accounts today for their potential as an income producer, volatility dampener, and duration diversifier. All three have been on exhibit in this still-young calendar year.