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Opinions abound on floating-rate loan credit health

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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 Scott H. Page, CFA, Co-Director of Floating-Rate Loans, Eaton Vance Management

      Boston - We've managed client assets in floating-rate corporate loan strategies since 1989. Our longest-running fund will surpass its 30-year mark in 2019. Along the way, we've developed deep expertise in this asset class. We manage more than $45 billion in floating-rate corporate loan assets (as of 10/31/2018), for clients all around the globe and in every discernible delivery format.

      As experts in this field, recent media coverage surrounding floating-rate loans reminds us of the phenomenon of Gell-Mann's Amnesia. Coined by the late Michael Crichton, the author and film director made the reference in relation to his physicist friend Murray Gell-Mann, who discovered (and named) the concept. To quote Crichton's "Why Speculate?":

      Media carries with it a credibility that is totally undeserved. You have all experienced this, in what I call the Murray Gell-Mann Amnesia effect. (I call it by this name because I once discussed it with Murray Gell-Mann, and by dropping a famous name I imply greater importance to myself, and to the effect, than it would otherwise have.)

      Briefly stated, the Gell-Mann Amnesia effect works as follows. You open the newspaper to an article on some subject you know well. In Murray's case, physics. In mine, show business. You read the article and see the journalist has absolutely no understanding of either the facts or the issues. Often, the article is so wrong it actually presents the story backward--reversing cause and effect. I call these the "wet streets cause rain" stories. Paper's full of them.

      In any case, you read with exasperation or amusement the multiple errors in a story - and then turn the page to national or international affairs, and read with renewed interest as if the rest of the newspaper was somehow more accurate about far-off Palestine than it was about the story you just read. You turn the page, and forget what you know.

      That is the Gell-Mann Amnesia effect. I'd point out it does not operate in other arenas of life. In ordinary life, if somebody consistently exaggerates or lies to you, you soon discount everything they say. In court, there is the legal doctrine of "falsus in uno, falsus in omnibus", which means untruthful in one part, untruthful in all.

      But when it comes to the media, we believe against evidence that it is probably worth our time to read other parts of the paper. When, in fact, it almost certainly isn't. The only possible explanation for our behavior is (actual) amnesia.

      Back to loanland, we've always been a little dismayed by the hyperbole so frequently found in media coverage surrounding our asset class. The market never just "grows". It's "explosive growth". Credit conditions never just weaken. It's "extremely aggressive underwriting". And so on and so forth. Take a kernel of fact and then completely twist the meaning. As the latest examples, references to "covenant-lite" or "loan only" capital structures have increasingly been invoked, sparking fear (and driving web clicks) but without the "yes, but" context required to garner a complete understanding - full disclosure that in our opinion would leave most people unworried and more than likely encouraged. But no matter: Splashy headline printed, click generated, advertiser dollars raised.

      All of the above is exactly why we don't get our news from newspapers. By contrast, research providers, the asset management community and other centers of expertise are not sounding the alarm in loans that you're seeing in the financial media. The biggest names in financial reporting continue to one-up each other in a circular game of hyperbole that seems to never end. Some have recently gone so far as to compare senior corporate loans to the subprime mortgages that led to the financial crisis. Really?! We're sorry, but a secured loan to a large corporation with transparent operating performance and a 30-40% loan-to-value (LTV) is NOT the same as 100% financing to poor credit score individuals with little to no documentation of income and assets.

      To close, here are some basic credit statistics regarding the issuers comprising the S&P/LSTA Leveraged Loan Index, which by-and-large represents our asset class universe:

      • First, the ability to generate cash: Year-over-year EBITDA growth is most recently +12%, produced on revenue growth of +14%. These results are up from the healthy year-ago figures of +5% and +10%, respectively. Issuer operating performance has strengthened on average.
      • Second, indebtedness: The weighted average total leverage in our market is most recently 5.44x EBITDA, which is down from 5.94x a year ago. Companies on average are less (not more) indebted today. In fact, leverage is at a cycle low.
      • Third, debt serviceability: Interest coverage is most recently 4.42x on a weighted average basis. This is an all-time ever high, meaning debt affordability has never been stronger.

      Source: S&P/LCD, 9/30/2018.

      For all of these reasons, and supported by a solid underlying economic backdrop, the trailing 12-month default rate for the Index is just 1.92%, which is lower than the same mark a year ago and well below the approximate 3% long-term average. And while defaults are by definition backward looking, the distress ratio (defined as the percentage of loans trading less than $80) tends to be a forward indicator of market stress. This mark is just 1.5% today, down by 50% compared with 3% a year ago. (Source for all data in this paragraph: S&P/LCD, as of 10/31/2018.)

      Bottom line: There are always numbers to crunch and fine print to read in covenants. As active managers, that's where we spend our days. We believe loan market fundamentals are on solid footing today, and the asset class remains well positioned to potentially deliver more of the yield and anti-bond characteristics that have defined 2018 thus far. Always remember the lessons of Gell-Mann, and always consider the source.

      The value of loan investments may increase or decrease in response to economic, and financial events (whether real, expected or perceived) in the U.S. and global markets. Loans are traded in a private, unregulated inter-dealer or inter-bank resale market and are generally subject to contractual restrictions that must be satisfied before a loan can be bought or sold. Loans may be structured such that they are not securities under securities law, and in the event of fraud or misrepresentation by a borrower, lenders may not have the protection of the anti-fraud provisions of the federal securities laws. Loans are also subject to risks associated with other types of income investments. Investments in debt instruments may be affected by changes in the creditworthiness of the issuer and are subject to the risk of non-payment of principal and interest. The value of income securities also may decline because of real or perceived concerns about the issuer's ability to make principal and interest payments.