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Floating-rate loans in falling-rate periods: Let's look at the facts

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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 fund. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results.

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      By Craig P. Russ, Co-Director of Floating-Rate Loans, Eaton Vance Management and Christopher Remington, Institutional Portfolio Manager, Eaton Vance Management

      Boston - "Fed Day" has come and gone. No rate cut for now, but Federal Reserve Chairman Jerome Powell indeed scrapped his longstanding "patience" speak in favor of more of his "willingness to act as appropriate" talking points. While little was promised but readiness, there was also no push back against widespread market expectations for cuts ahead.

      All of this is seemingly a prelude to the Fed's first rate cut in more than a decade, perhaps as soon as next month. The futures markets are pricing in a near certainty of a cut in July, while the Fed's own "dot plot" projection shows that its board members are in fact relatively mixed on whether or not cuts actually occur this year.

      Whatever is the exact timing of things, it seems clear that the likely path of short-term rates is to move lower in the year ahead. What that portends for managers of a floating-rate product is that it's time yet again to dust off the responses to the many "what a rate cut means" inquiries related to our asset class.

      Most are rooted in the age-old misperception that senior corporate loans are best positioned in portfolios only during "rising-rate periods", and by extension that loans do not perform well at other times, least of all during periods of rate cuts.

      Let's turn to the facts. Consider the chart below, which summarizes performance during each of the three Fed rate-cut cycles experienced over the past two-plus decades. The analysis captures every rate-cut cycle since the inception of the loan market's S&P/LSTA Leveraged Loan Index in 1997.

      Specifically, the chart showcases the annualized forward returns of loans versus that of stocks and bonds, as measured from the time of the Fed's initial rate cut. As asset class proxies, we use the S&P 500 Index for stocks and the Bloomberg Barclays U.S. Aggregate Bond Index for bonds.

      Because the cycle of Fed cuts (and hikes, too) typically takes multiple years to play out, we assess the three-year forward period to both eliminate noise as well as capture a more complete picture of the relative investor experience across these asset classes.

      How have loans performed amid falling short-term rates?

      FRLPOST620

      In terms of observations on the chart, we'll offer three:

      1. It's clear that loans have consistently outperformed equities. As each period was marked by recession - for which Fed cuts were ultimately aimed at easing - economic contraction weighed on stock market returns, whereas loans' senior/secured character and income-oriented performance skew provided key ballast.
      2. While bonds were the clear winner, it's imperative to consider this within the context of the decades-long "bull run" for fixed income. Long-term rates were falling across all of the highlighted periods, a repeat of which is completely implausible given the flatness of today's yield curve and a low starting yield of just 2.69% yield on the "Aggregate". In our view, today's bond math simply cannot deliver the returns of the past.
      3. The experience of a typical "60/40 investor" would have been notably improved in every case above with the inclusion of the loan allocation. Not only in an absolute sense but in a risk-adjusted way as well. Loans have exhibited a fraction of equity volatility through time, blending well with stocks, while loans' floating coupon structure pairs well with all things "fixed".

      What's more? Is there any data to suggest these performance relationships shouldn't hold looking ahead? We don't think so. Could relative outcomes actually improve for loans? There can be no guarantee, but today's high stock multiples and extraordinarily low bond yields indeed give us comfort in the helpful role our asset class may play in portfolios in the years ahead.

      A couple final points to consider:

      • Rate cuts are "credit positive". The flip side of lower yields for investors is lower coupon payments for borrowers. Interest coverage in the loan market is already at or near all-time highs, and cuts would make the debt even more easily serviceable. And more generally, cuts are stimulative for the economy, which is by-and-large good for Corporate America.
      • Starting yield is one of the most reliable pre-determinants of forward returns. Don't overthink it. A typical loan fund yields 5-5.5% today.1 By comparison bond yields in much of the developed world are negative or close to zero. Loan yields are close to parity with high-yield bonds (by definition a riskier market), and they actually out-yield USD-pay emerging market sovereigns as well as emerging markets corporates, too.
      • An eventual rate cut or two is almost sure to transfer to lower base rates for loans. But consider that there's another important part of the loan yield, the credit spread. Over time spreads have tended to be lower when base rates are higher, and vice versa, spreads tend to offer a little more when base rates move lower. Basically: Just as spread tightening offset some of the benefit of Fed hikes in recent years, that relationship can and historically has worked in reverse. Spreads can buffer some of the impact of rate cuts.
      • Retail loan fund investors now command a mere 9% of loan market assets outstanding, down from a high of almost 25% in early 2014.2 After eight months of redemptions (during which loans produced solid returns, but we digress), fund holders have now consolidated to a more organic, core base of holders. Accounting for the more than 90% balance of the loan investor base are institutions. From pension funds to insurance companies, they continue to find the yield and risk/return characteristics of this asset class worthy.

      Bottom line: If you've relegated the senior loan asset class to a place in your thinking where it only fits for clients when rates are rising, consider rethinking. Loans have a place in portfolios through time, over all periods, inclusive of periods when short-term rates are falling.

      S&P Dow Jones Indices are a product of S&P Dow Jones Indices LLC ("S&P DJI") and have been licensed for use. S&P® and S&P 500® are registered trademarks of S&P DJI; Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC ("Dow Jones"); S&P DJI, Dow Jones and their respective affiliates do not sponsor, endorse, sell or promote the Fund, will not have any liability with respect thereto and do not have any liability for any errors, omissions, or interruptions of the S&P Dow Jones Indices. It is not possible to invest directly in an index. Historical performance of an index illustrates market trends and does not represent the past or future performance of a fund. Unless otherwise stated, index returns do not reflect the effect of any applicable sales charges, commissions, expenses, taxes or leverage, as applicable.

      S&P/LSTA Leveraged Loan Index is an unmanaged index of the institutional leveraged loan market.

      Standard & Poor's 500 Index is an unmanaged index of large-cap stocks commonly used as a measure of U.S.stock market performance.

      Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index of domestic investment-grade bonds, including corporate, government and mortgage-backed securities.