It's Loan-Ly At The Top

by: Eaton Vance

Summary

With capital markets experiencing outsized volatility, why – and how – have loans delivered such relative stability?

We see lower loan prices in August as a reflection of short-term supply/demand factors and evidence of a healthy and functioning secondary market, nothing more.

We believe as the capital markets react to a new era of U.S. monetary policy and recent developments in China, it’s really not surprising to see a pickup in volatility and a repricing of risk assets.

By Christopher Remington, Director of Institutional Portfolio Management

The absence of instability in the floating-rate loan market has drawn some attention in recent days. With capital markets experiencing outsized volatility, why - and how - have loans delivered such relative stability? To us, the strategic case has always been best made in microcosms. The recent stretch is just the latest shining example.

Though the absolute return may be modest, loans remain a giant in relative terms in 2015: +2% year-to-date results through Tuesday (as measured by the S&P/LSTA Leveraged Loan Index) have bested equities of all market caps and styles and, notably, high-yield bond strategies of any and all credit gearings - a cast of characters that today sit markedly in the red, alongside emerging markets, commodities, currencies and more.

Meanwhile, loans have handily outpaced core and core-plus strategies - as modicum spreads have compensated little and higher Treasury rates have taken their toll.

On how loans have delivered as they have this year, it really comes down to the basic features that make loans unique, and thus, effective portfolio diversifiers:

  • Low equity market beta* - thanks to a strong technical anchoring to par and a fundamental risk/return profile at the polar opposite (i.e., low) end of the spectrum.
  • Senior/secured status - translates to lower credit risk - and by extension, often lower volatility - relative to "equity hybrid" high-yield bonds.
  • Floating-rate coupons - providing the all-important offset to the duration pain felt in high-grade bond segments year to date.

But what about the latest volatility witnessed here in August? Loan prices are indeed softer month-to-date, with the market posting a total return of -0.81% for August through Tuesday (as measured by the S&P/LSTA Leveraged Loan Index). In relative terms, the pattern noted above has held yet again, with high-yield bonds down threefold and many equity indices experiencing double-digit negative results. But why are loan prices off at all?

A "risk-off" sentiment in the short run can and sometimes does bleed over into the asset class. That's presented itself primarily through a modest pickup in retail fund redemptions - nothing like last year or early 2015, but a pickup nonetheless - as well as outflows from high-yield bond funds, some of which have been selling loans amidst recent withdrawals.

Recent pricing notwithstanding, we see little in world developments today that seem to threaten the U.S. economic recovery or the underlying fundamental credit risk in this asset class. In fact, quite the contrary: A limited number of trouble spots aside - always present in a sub-investment grade market - we broadly see debt multiples in check, near-record interest coverage and maturities that have been pushed out to 2018 and beyond. We also see the U.S. on solid footing. We see lower loan prices in August as a reflection of short-term supply/demand factors and evidence of a healthy and functioning secondary market, nothing more.

We believe as the capital markets react to a new era of U.S. monetary policy and recent developments in China, it's really not surprising to see a pickup in volatility and a repricing of risk assets. Much of the recent weakness is likely overdone, as markets have a strong tendency to overshoot. Loans have provided much needed ballast, as they've so often done.

Bottom line: A supportive narrative from the Federal Reserve appears to be a positive for the asset class looking ahead, and frankly, the timing of the Fed's "first move" seems to matter little. We see the recent bout of softening as an opportunity.

*Beta measures the volatility of a security or asset class relative to the overall market.

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