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Twice in a lifetime opportunity in senior loans

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

      Boston - Right now credit markets are taking their cue from equities, which in turn have sharply repriced risk amid the ongoing virus situation and swirling policy response — and of course the unknowable economic cost of it all. The velocity of the downturn in financial assets has been truly breakneck. The S&P 500 Index has lost a third of its value from its all-time high just last month, marking the fastest slide from a market peak to a bear market — ever. In most previous bear markets, it has taken one to two years for equities to bottom. The current selloff has taken a mere month.

      The picture has been mirrored in the credit space: Markets remain unsettled and choppy against the backdrop of widespread investor panic. The loan market's S&P/LSTA Leveraged Loan Index closed yesterday (Thursday, March 19) at an average price of 78.4. Meantime in the high-yield bond market credit spreads gapped to just inside 1,000 basis points. For context, investors assigned values to these figures of 95 and just under 400 basis points barely three weeks ago.

      In past selloffs, loans have snapped back sharply

      Avgloanpriceforwardreturnsblog0320small

      Source: LCD, an offering of S&P Global Market Intelligence, 03/19/2020. Past performance is not a reliable indicator of future results. Data provided are for informational use only. It is not possible to invest directly in an Index. See end of material for important additional information and disclosures.

      Let's put the recent loan market volatility in context:

      • The loan index has just experienced four separate "single worst days in asset class history" — in only the last five trading sessions. Re-read that line. Has the value of these loans changed so much in a week? Certainly the price has — and the speed and depth of the drop is nothing short of historic.
      • Loans' sharp month-to-date March loss now stands at -17.3%. For context, the three "worst months ever" for loans included: October 2008 (down -13.2%), November 2008 (-8.5%) and September 2008 (-6.2%). In under three weeks this month loans have "out-plunged" the absolute worst parts of the Great Financial Crisis.
      • Loans priced at or below 90 (let alone below 80) has historically served as a key overweight signal for opportunistic investors. The same goes for high-yield bond spreads over 800 (let alone almost 1,000). Current valuations in both markets appear to have quickly priced in the end of the world, the likes of which neither market has ever come close to seeing. 
      • Consider loan prices at 78. If the defaults of the future were to experience the typical 80% recoveries of the past, this would imply the market is pricing a default rate of 110% -- a mathematical impossibility. Of course, the market may also be anticipating a lower recovery rate than we have experienced historically - say, 70%. Assuming that recovery rate, the implied forward default rate expectation is still a whopping 75%. For context, cumulative defaults in the crisis-era totaled 5x less at 15%. And today's current one-year default rate is just 1.8%.
      • Here's another sign of the technical nature of what's afoot: The selloff in loans has been broadly based and absolutely indiscriminate, cutting across every rating category and sector in this $1.2 trillion asset class. In other words, the hit hasn't come to just the limited share of the market most directly exposed to virus fallout — airlines, hotels/casinos, theaters, etc. Literally, everything is down, and sharply.
      • A colleague of ours likes to say "stocks are hope, bonds are math." While surely less than fair to equities, we can't agree more with the bond math part. The YTM (yield-to-maturity) of the loan Index stands at 12%. Loans have a par value, and that value is secured with a senior claim.

      Loan prices may go up or down in the near term — headlines and flows will dictate that — but it's clear to us that the market's technical pressure has overshot the fundamental value inherent in this asset class.

      Remember, price is what you pay. Value is what you receive. We believe senior loans trading at 78 imply one of the best values in this market's history.

      Bottom line: It may feel scary now. The lows of past selloffs did as well. The dust will settle, and this too shall pass. When it does, history shows us that the snap-backs were worth the wait.