The Timeless Case for Floating-Rate Loans As a Strategic Allocation

EATON VANCE TOPIC PAPER • JULY 2016

The timeless case for floating-rate loans as a strategic allocation

Scott Page, CFA Floating-rate loans deserve consideration as a strategic Co-Director of Floating-Rate Loans Portfolio Manager Eaton Vance Management portfolio allocation because they can offer: Craig Russ Co-Director of Floating-Rate Loans Portfolio Manager 1. Attractive yields – The yield on loans was second only Eaton Vance Management Christopher Remington to high yield among U.S. fixed-income sectors (as of Director of Income Product & Portfolio Strategy June 30, 2016). Eaton Vance Management 2. Protection against interest-rate risk – Loans have near-zero interest-rate duration and rates that move with the underlying benchmark – typically Libor.

3. A structure designed to mitigate credit risk – Senior/ secured positioning in the capital structure offers a layer of protection that is unique in the corporate fixed-income market.

4. A forward-looking allocation – Loans historically have outperformed the broad bond market in flat- and rising- rate environments, thanks to historically low correlation with traditional fixed-income sectors. We believe loans are likely to be an important source of diversification in the coming years. EATON VANCE TOPIC PAPER • JULY 2016 • TIMELESS CASE FOR FLOATING RATE LOANS • 2

Floating-rate loans occupy a unique capital-market niche. What are floating-rate loans?1 Nothing else in the fixed-income universe combines: Floating-rate loans represent below-investment-grade debt of §§ Yields that were second only to high-yield bonds among corporate issuers, which frequently use the market for a U.S. sectors, as of June 30, 2016. variety of purposes such as recapitalizations, acquisitions and refinancings. Most issuers are of significant size and §§ The potential to boost total return when rates rise. scale, and many are familiar household names, like Burger King, Dell and American Airlines. It is a broadly diversified §§ A structure designed to mitigate credit risk with senior/ market, with more than 1,200 issues comprising the Index, secured positioning in the capital structure. from issuers across 27 different sectors (Exhibit A). The value of floating-rate loans has been proven across a Today’s loan market is built on a conservative bank lending number of credit cycles, thanks to disciplined underwriting tradition that emphasizes due diligence and strict standards with a significant margin of safety. Despite the underwriting standards. Loans were first originated and price fluctuations of the financial crisis, since 2001 loans syndicated among a relatively small number of banks. But that have returned more than 99% of principal and about 500 arrangement has evolved into a thriving capital market, basis points (bps) of annual income, based on the S&P/LSTA including a wide range of institutional investors and the Leveraged Loan Index (the Index). This paper outlines how participation of a number of loan managers. The par amount fixed-income portfolios can potentially be enhanced by outstanding in the U.S. market has increased from a negligible floating-rate loans, and why we believe they should be level to almost $900 billion over the past 20 years (Exhibit B), included as a strategic allocation. including a deep and active secondary market.

Exhibit A A diverse range of (often familiar) issuers use the floating-rate loan market.

Lodging & Casinos Health Care All Telecom Business Equipment & Services Retailers (except food & drug) Electronics/Electrical Utilities Cable & Satellite Television Food Service Drugs Automotive Leisure Goods/Activities/Movies Radio & Television Insurance Financial Intermediaries Publishing Building & Development Aerospace & Defense Food/Drug Retailers Nonferrous Metals/Minerals Steel Industrial Equipment Oil & Gas Containers & Glass Products Chemicals & Plastics Air Transport Ecological Services & Equipment 0% 2% 4% 6% 8% 10%

Source: S&P/LSTA, April 30, 2016.

1Floating-rate loans are also known as leveraged loans, senior loans and bank loans. EATON VANCE TOPIC PAPER • JULY 2016 • TIMELESS CASE FOR FLOATING RATE LOANS • 3

Exhibit B The loan market has grown dramatically over the past two decades.

$1,000

$800

$600

$400 Billions

$200

$0 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 YTD '16

Source: S&P/LSTA, April 30, 2016.

1. Attractive yields behind U.S. high yield and local currency emerging-market bonds – almost three times the yield on the Barclays U.S. The yields available from floating-rate loans are typically Aggregate Index (Exhibit C). In a world of microscopic and among the highest global fixed-income sectors. For example, negative interest rates, this level of return could be a on April 30, 2016, the 6.1% yield on loans ranked third, welcome addition to a fixed-income portfolio.

Exhibit C Loans have been among the highest-yielding fixed-income sectors.

8% 7.4%

7% 6.4% 6.1% 6% 5.8% 5% 4% 3.1% 3% 2.4% 2.2% 1.8% 2% 1.4% 1.3% 1% 0.8% 0%

EM Bond US MBS US Agency Global Agg US Treasury US High Yield US Aggregate (Local Curr.) EM Bond (USD) Municipal Bond Floating-Rate Loan US Corp. Inv. Grade Sources: Barclays, JPMorgan, Standard & Poor’s, as of April 30, 2016. Data provided are for informational use only. Past performance is no guarantee of future results. It is not possible to invest directly in an Index. See end of report for important additional information. High Yield is represented by Barclays U.S. Corporate High Yield. U.S. EM Bond (Local Currency) is represented by JPMorgan Government Bond Index-Emerging Markets (GBI-EM) Global Diversified. Floating-Rate Loans are represented by S&P/LSTA Leveraged Loan Index. EM Bond is represented by JPMorgan Emerging Markets Bond Index Plus(EMBI+). U.S Corporate Investment Grade is represented by Barclays U.S. Corporate Investment Grade Index. U.S. MBS is represented by Barclays U.S. Mortgage- Backed Securities (MBS) Index. U.S. Aggregate refers to the Barclays U.S. Aggregate Bond Index. Municipal Bond is represented by the Barclays Municipal Bond Index. U.S. Treasury is represented by Barclays U.S. Treasury Index. U.S. Agency is represented by Barclays U.S. Agency Index. Global Agg is represented by Barclays Global Aggregate Ex-USD Index. EATON VANCE TOPIC PAPER • JULY 2016 • TIMELESS CASE FOR FLOATING RATE LOANS • 4

Loan yields have provided historically strong support for total shows how loans have the highest ratio of yield per unit of return. The distribution of quarterly total returns on loans duration versus other major fixed-income sectors. The chart since 1992 in Exhibit D shows that those returns were underscores the extent to which the yield on traditional positive 86% of the time, illustrating how their income fixed-income sectors comes at the price of interest-rate stream can cushion price fluctuations. As we will see next, vulnerability. Exhibit E (right) rounds out the picture, that’s especially valuable when interest rates are a big factor showing loans have had low correlation with other sectors, weighing on prices of traditional bonds. thanks to their low interest-rate sensitivity.

Exhibit D Thanks to the income stream on loans, negative loan returns have been rare. Distribution of quarterly total returns 1992 - Q1 2016

40 Negative Quarters 37 Positive Quarters 35 Returns have been positive in 30 86% of quarters since 1992. 25

20 18

15 13 Q1 2008 Number of Quarters 10 Q3 2008 8 Q4 2008 4 5 5 3 4 3 0 1 1 0 <-5% -5% to -4% -4% to -3% -3% to -2% -2% to -1% -1% to 0 0 to 1% 1% to 2% 2% to 3% 3% to 4% 4% to 5% >5%

Source: Zephyr, as of March 31, 2016. Data provided are for informational use only. Past performance is no guarantee of future results. It is not possible to invest directly in an Index. See end of report for important additional information. Loan performance is represented by the Credit Suisse Leveraged Loan Index.

2. Protection against interest-rate risk Looking back at the past three periods of rising rates since One of the basic features of floating-rate loans is that their 1994 in Exhibit F, the historical performance of loans versus coupons reset every 40 to 60 days, on average, with bonds bears out the concepts in Exhibit E. For example, when adjustments that are calculated as fixed spread over a the Federal Funds rate increased by 300 basis points for the variable benchmark – typically the London Interbank Offered 12 months ended February 1995 loans returned 10.4% Rate, or Libor. For example, on March 31, 2016, the Index compared with 0.01% for bonds. Most recently, when the traded at Libor + 658 basis points. This means that U.S. Federal Reserve raised rates from 1.0% to 5.25% over floating-rate loans have negligible duration – rates rise in the two years ended June 2006, loans returned 12.7% vs. tandem with Libor. 6.6% for bonds. When you combine the facts that loans have had higher 3. A structure designed to mitigate credit risk historical yields and lower duration than traditional bonds, Loans have a layer of credit protection that is extremely rare you wind up with the Exhibit E scatterplot on the left. It in the corporate fixed-income market, thanks to their senior/ EATON VANCE TOPIC PAPER • JULY 2016 • TIMELESS CASE FOR FLOATING RATE LOANS • 5

Exhibit E Floating-rate loans: The highest yield/duration ratio and lowest correlation with other debt.

Yield vs. duration 10-yr. correlation with US Treasurys

10 1.0 US High Yield 1.00 0.92 0.8 0.84 0.80 8 0.6 US Floating-Rate Loan US EM Bond 0.4 0.41 6 0.2 0.28 0.20 0.0 US Corp. IG -0.26 4 -0.2 Yield (%) US MBS US Agg -0.4 -0.46 2 -0.6 US Agency US Treasury Global Agg

Treasury US Agg US MBS 0 US Agency Municipal 0 1 2 3 4 5 6 7 8 US Corp. IG US Floating-Rate Loan US High Yield Duration (Years) EM Bond (USD)

Sources: Barclays, JPMorgan, Standard & Poor’s, as of April 30, 2016. Data provided are for informational use only. Past performance is no guarantee of future results. It is not possible to invest directly in an Index. See end of report for important additional information. High Yield is represented by Barclays U.S. Corporate High Yield. U.S. EM Bond (Local Currency) is represented by JPMorgan Government Bond Index-Emerging Markets (GBI-EM) Global Diversified. Floating-Rate Loans are represented by S&P/LSTA Leveraged Loan Index. EM Bond is represented by JPMorgan Emerging Markets Bond Index Plus(EMBI+). U.S Corporate Investment Grade is represented by Barclays U.S. Corporate Investment Grade Index. U.S. MBS is represented by Barclays U.S. Mortgage- Backed Securities (MBS) Index. Municipal Bond is represented by the Barclays Municipal Bond Index. U.S. Treasury is represented by Barclays U.S. Treasury Index. U.S. Agency is represented by Barclays U.S. Agency Index. Global Agg is represented by Barclays Global Aggregate Ex-USD Index. U.S. Agg refers to the Barclays U.S. Aggregate Index.

Exhibit F Loans have handily outperformed bonds in rising rate periods.

8 6/99 – 5/00 6/04 – 6/06 7 Loans: 3.9% Loans: 12.7% Bonds: 2.1% Bonds: 6.6% 6

3 2/94 – 2/95 Fed Funds Target Rate (%) Rate Target Funds Fed 2 Loans: 10.4% Bonds: 0.1% 1

0 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16

Source: Morningstar, March 31, 2016. Data provided are for informational use only. Past performance is no guarantee of future results. It is not possible to invest directly in an Index. See end of report for important additional information. Performance is cumulative and rising rates are defined as any period where the federal funds target rate increased at least 1%. Loan performance is represented by Credit Suisse Leveraged Loan Index. Bond performance is represented by Barclays U.S. Aggregate Index. EATON VANCE TOPIC PAPER • JULY 2016 • TIMELESS CASE FOR FLOATING RATE LOANS • 6

secured positioning in the issuer’s capital structure, as 99% of principal has been returned to investors over a illustrated in Exhibit G. In the event of default, the claims of period that has been stressed by two recessions, including loan investors are ahead of those for high-yield bonds and the “great” one of 2008. equity. Because loans comprise 31% of the capital structure, the junior layers of high yield and equity amount to a 4. A forward-looking allocation “capital cushion” equivalent to about two-thirds of the The history of loan performance over the past 20 years – part of enterprise value (Exhibit G). In addition, loans are typically the greatest bond bull market in modern history – provides secured by specific corporate assets. This conservative important clues as to why loans may be key in forward-looking “belts-and-suspenders” approach to lending has been very portfolio positioning as we start on the next 20. effective: Over the past 20 years, loans have had a 70% recovery rate from bankruptcies, based on 20 years of For the 20 years ended December 31, 2015 the yield on experience at Eaton Vance, compared with 40% for high- 10-year U.S. Treasury notes fell from 7.6% to 2.3%. This yield bonds. was a tremendous tailwind for traditional bonds, as falling

Exhibit G Senior positioning for loans is a cushion against credit risk.

Avg. of loan issuers across Eaton Vance strategies, as of Dec. 31, 2015.

12 $ Billions / % of Capital Structure

Weighted average company capital 10 structure: Loans $3.4 / 31%

8 • Revenue: $5.2 billion High-Yield $1.5 / 14% Bonds • EBITDA: $868 million 6

• Enterprise Value: $11 billion $ Billions 4 Equity $6.1 / 55% 2

Source: Eaton Vance as of December 31, 2015. Data provided are for informational use only. Past performance is no guarantee of future results. It is not possible to invest directly in an Index. See end of report for important additional information. This information is for illustrative purposes only, is subject to change at any time and should not be considered investment advice or a recommendation to buy or sell any particular security or adopt any particular strategy. The sample is an average of all loans currently tracked across the Eaton Vance loan platform as of December 31, 2015. It does not represent any particular issuer or product. EBITDA is a common measure of corporate cash flow that is defined as earnings before interest taxes depreciation and amortization.

Exhibit H shows the powerful impact of the 70% average rates pushed up their prices and boosted total return – a recovery rate on loans over the past 15 years. With 70% relative advantage for bonds over loans, whose prices are being recovered, net credit loss amounts to 30% of the 3% relatively unaffected by interest-rate changes. That is average default rate since 2001, or about 1%. That means reflected in the average annual returns of 5.3% for the EATON VANCE TOPIC PAPER • JULY 2016 • TIMELESS CASE FOR FLOATING RATE LOANS • 7

Exhibit H Conservative loan structure has held net credit losses to 1% average over 15 years.

12 Default rate Net credit loss 10 Average net credit loss

6 Percent 4

0 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16

Barclays U.S. Aggregate Index over the 20-year period, To us, this analysis underscores the importance of fixed- versus 4.9% for the Credit Suisse Leveraged Loan Index. income diversification based on expected performance characteristics. Generally, floating-rate loans are at a relative Nevertheless – and surprisingly – even during this epic bull disadvantage as rates decline and yields are reduced, but run for the Barclays U.S. Aggregate Index, loans have a relative advantage as rates rise. Flat interest-rate outperformed that index 64% of the time, when we look at environments would also tend to give the yield edge to the 276 rolling one-year periods since 1992 and classify floating-rate loans because they are generally higher-yielding them as flat-, rising- or falling-rate.2 (The interest-rate below-investment-grade quality, while the Barclays U.S. direction was determined by the change in the U.S. fed Aggregate Index tracks lower-yielding investment-grade funds rate over the period.) bonds. Loans proved their worth as a diversifier in the As illustrated in Exhibit I, loans outperformed bonds during majority of times when rates were rising or flat. the 86 rising rate periods, by an average 7.3% vs. 4.6%, If we pivot to the likelihood of future possibilities, we find and during the 91 flat rate periods, 8.4% vs. 5.4%. During both short- and long-term rates near their lower bounds, the the 99 falling rate periods, bonds outperformed loans by an U.S. Federal Reserve starting (with all due caution) to raise average of 7.7% to 2.8%. rates and other global central banks keeping rates at zero or less.

2For purposes of this analysis, we went back 24 years, to start at the inception of the Credit Suisse Leveraged Loan Index. EATON VANCE TOPIC PAPER • JULY 2016 • TIMELESS CASE FOR FLOATING RATE LOANS • 8

Exhibit I Loans have outperformed bonds in flat- and rising-rate periods.

Bonds Outperformed 86 Rising Rate Periods Summary: Avg. return for 86 1-year periods Loans: 7.3% Bonds: 4.6% 86 Rising 99 Falling Rate Periods Rate Periods 91 Flat Rate Periods Summary: Avg. return for 91 1-year periods Loans: 8.4% Bonds: 5.4%

Loans 91 Flat 99 Falling Rate Periods Outperformed Rate Periods Summary: Avg. return for 99 1-year periods Loans: 2.8% Bonds: 7.7%

Eaton Vance, December 31, 2015. Data provided are for informational use only. Past performance is no guarantee of future results. It is not possible to invest directly in an Index. See end of report for important additional information. Loans are represented by Credit Suisse Leveraged Loan Index and bonds are represented by the Barclays U.S. Aggregate Index. Analysis includes all rolling one-year periods since inception of Credit Suisse Leveraged Loan Index in February 1992.

Exhibit J uses the basic bond math of duration and could include change due to investor sentiment about credit hypothetical interest-rate moves to illustrate the potential risk in general (or of particular issuers), the spread level impact on total return over one year. For example, if we between investment-grade and below-investment-grade debt assume rates will stay close to flat, the yield advantage of and so forth. We simply wish to illustrate the principle of loans works out to a 3.6 point advantage in return. If rates duration risk and the importance of positioning portfolios to increase by 100 basis points (bps), the differential between account for it. loans and the Barclays U.S. Aggregate Index widens to 10 points. Falling rate scenarios (which are much less likely, in A proven tool for managing uncertainty our view) turn the advantage to the Barclays U.S. Aggregate Both interest rates and credit risk are cyclical. The insight Index after a decline of more than 50 bps. that has made floating-rate loans useful and enduring is that Exhibit I shows how loans had value as a portfolio diversifier these cyclical risks can be managed through a prudent even when the overall tail wind for bonds was strong for two lending structure – one that benefits both investors seeking decades. Exhibit J points to how much more valuable loans higher rates and below-investment-grade issuers seeking could be, now that the era of large interest-rate declines market access. In our opinion, the risks can further be is history. mitigated with the due diligence and expertise of professional management – we do not believe it is a It’s important to note we have not discussed other factors market that lends itself to the “commoditization” of that can influence price movements of both loans and the passive strategies. Barclays U.S. Aggregate Index, besides interest rates. This EATON VANCE TOPIC PAPER • JULY 2016 • TIMELESS CASE FOR FLOATING RATE LOANS • 9

Because it’s impossible to pinpoint when the next rising rate rates tack back upward. Whether we are on the cusp of a scenario will occur, the track record of loans makes a good new cycle of rising rates, or some ways away from it, loans case for a strategic allocation – one that benefits from strong still offer an immediate benefit: the luxury of not having to current yields, combined with “insurance” for the day when make that call.

Exhibit J The value of loans may increase significantly if rates stay flat or rise. Hypothetical one-year returns

10% 7.6% 7.8% 7.7% 6.7% 7.1% 5.8% 5.8% 4.9% 4.9% 5.3% 5% 2.2%

0% -0.6% -3.3% -5% -6.1% -8.8% -10% -9.9%

-15%

Bonds Loans -20% -100 -50 flat +50 +100 +150 +200 +220 Assumed Interest-Rate Change (basis points)

Source: Eaton Vance as of March 31, 2016. Data provided are for informational use only. Past performance is no guarantee of future results. It is not possible to invest directly in an Index. See end of report for important additional information. Bonds are represented by the Barclays U.S. Aggregate Index, with a yield of 2.2% and duration of 5.5 years. For loans, we use the S&P/LSTA Index, with a net yield of 5.8%, based on a market yield of 6.5%, reduced by 0.7 percentage points to account for expected defaults and recoveries — the average level observed by Eaton Vance over 20 years. Duration is 0.1 years. Return calculations are based on standard duration formula, assuming parallel shifts in the yield curve, instantaneous rises in interest rates and adjustments of benchmark yields over a one-year period. Chart represents projections based on various interest-rate scenarios, but is not intended to predict any particular scenario. The information is based, in part, on hypothetical assumptions and the experience of Eaton Vance. Certain of the assumptions have been made for modeling purposes and are unlikely to be realized. Changes in the assumptions and scenarios may have a material impact on the information shown. EATON VANCE TOPIC PAPER • JULY 2016 • TIMELESS CASE FOR FLOATING RATE LOANS • 10

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

Barclays U.S. Treasury Index is an unmanaged index of U.S. Treasury securities, and a component of the Barclays U.S. Aggregate Bond Index.

Barclays U.S. Corporate Investment Grade Index is an unmanaged index that measures the performance of investment-grade corporate securities within the Barclays U.S. Aggregate Index.

Barclays U.S. Mortgage Backed Securities (MBS) Index measures agency mortgage-backed pass-through securities issued by GNMA, FNMA and FHLMC.

Barclays U.S. Corporate High Yield Index measures USD-denominated, noninvestment-grade corporate securities.

Barclays Municipal Bond Index is an unmanaged index of municipal bonds traded in the U.S.

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

Credit Suisse Leveraged Loan Index is an unmanaged index of the institutional leveraged loan market.

Barclays Global Aggregate Ex-USD Index is a broad-based measure of global investment-grade fixed-rate debt investments, excluding USD-denominated debt.

JPMorgan Government Bond Index-Emerging Markets (GBI-EM) Global Diversified is an unmanaged index of local currency bonds with maturities of more than one year issued by emerging-market governments.

Unless otherwise stated, index returns do not reflect the effect of any applicable sales charges, commissions, expenses, taxes or leverage, as applicable. It is not possible to invest directly in an index. Historical performance of the index illustrates market trends and does not represent the past or future performance. EATON VANCE TOPIC PAPER • JULY 2016 • TIMELESS CASE FOR FLOATING RATE LOANS • 11

About Eaton Vance Eaton Vance is a leading global asset manager whose history dates to 1924. With offices in North America, Europe, Asia and Australia, Eaton Vance and its affiliates offer individuals and institutions a broad array of investment strategies and wealth management solutions. The Company’s long record of providing exemplary service, timely innovation and attractive returns through a variety of market conditions has made Eaton Vance the investment manager of choice for many of today’s most discerning investors. For more information about Eaton Vance, visit eatonvance.com. EATON VANCE TOPIC PAPER • JULY 2016 • TIMELESS CASE FOR FLOATING RATE LOANS • 12

About Risk An imbalance in supply and demand in the income market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. There can be no assurance that the liquidation of collateral securing an investment will satisfy the issuer’s obligation in the event of nonpayment or that collateral can be readily liquidated. The ability to realize the benefits of any collateral may be delayed or limited. Investments in income securities may be affected by changes in the creditworthiness of the issuer and are subject to the risk of nonpayment 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. Borrowing to increase investments (leverage) will exaggerate the effect of any increase or decrease in the value of Fund investments. Investments rated below investment grade (typically referred to as “junk”) are generally subject to greater price volatility and illiquidity than higher-rated investments. As interest rates rise, the value of certain income investments is likely to decline. Bank loans are subject to prepayment risk. Investments in foreign instruments or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical or other conditions. In emerging or frontier countries, these risks may be more significant. Changes in the value of investments entered for hedging purposes may not match those of the position being hedged.

Important Information and Disclosure This material is presented for informational and illustrative purposes only as the views and opinions of Eaton Vance as of the date hereof. It should not be construed as investment advice, a recommendation to purchase or sell specific securities, or to adopt any particular investment strategy. This material has been prepared on the basis of publicly available information, internally developed data and other third-party sources believed to be reliable. However, no assurances are provided regarding the reliability of such information and Eaton Vance has not sought to independently verify information taken from public and third-party sources. Any current investment views and opinions/analyses expressed constitute judgments as of the date of this material and are subject to change at any time without notice. Different views may be expressed based on different investment styles, objectives, opinions or philosophies. This material may contain statements that are not historical facts, referred to as forward-looking statements. Future results may differ significantly from those stated in forward-looking statements, depending on factors such as changes in securities or financial markets or general economic conditions. Actual portfolio holdings will vary for each client. Investing entails risks and there can be no assurance that Eaton Vance, or its affiliates, will achieve profits or avoid incurring losses. It is not possible to invest directly in an index. Past performance is no guarantee of future results.