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.