Both monetary and fiscal policy will provide a level of support to fixed-income markets, but will also cause distortions, leading to both opportunities and the possibility for value traps, according to the new quarterly outlook from the Eaton Vance core bond team.
By Andrew Sveen, CFACo-Director of Floating-Rate Loans, Eaton Vance Management and Craig P. RussCo-Director of Floating-Rate Loans, Eaton Vance Management
Boston - Eaton Vance and its affiliates seek to actively capitalize on opportunities presented by uncertainty about future market and economic outcomes, while ensuring that the portfolio risk profile remains appropriate for the specific strategy. Here are excerpts from a recent conversation with Andrew Sveen, CFA, and Craig P. Russ, Portfolio Managers, Co-Directors of Floating-Rate Loans for Eaton Vance Management.
What we are seeing: With seemingly little notice by anyone outside the senior corporate loan market, the asset class where we spend our waking hours has quietly propelled itself to a historic rally. There are still a few trading days to go in the quarter, and the S&P/LSTA Leveraged Loan Index's quarter-to-date performance already stands at approximately 11%.
If the second quarter were to end on June 23, it would be logged as the market's second-best calendar quarter ever. And if measured off the loan market's bottom late in the first quarter on March 23, the index would be up almost 18% in just 12 weeks. To put the rally in perspective, that's more than three years of typical coupon income in this asset class in only three months.
Yet loans still trade at historically cheap levels in spite of this, underscoring the depth of the market plunge in the immediacy of the COVID panic and investors' rush from capital markets. The average price of the index stands at 91 — up sharply from the low of 77 in late March, though still four or five points shy of our default-adjusted approximation of fair value. We'd characterize loans this way: attractive coupon income, modest appreciation potential and a unique performance character that tends to blend well with other portfolio fare.
What we are doing: As always, we're of course minding our credits and tending to the daily business of portfolio management, trading and the new-issue calendar. We're also answering a pickup in inbound investor questions, and these have cut across an array of topics that suggest interest or at least curiosity in our space. One popular set of questions surrounds LIBOR1 — will loans ever float again? Another focuses on the role and risk of collateralized loan obligations — do CLOs pose a risk to loan investors?
In the case of rates, LIBOR has exceeded 100 basis points only about one-third of the time in the past 10 years, and the latest guidance from the Federal Reserve signals no plans to raise rates any time through 2022. In fact, the Fed is "not even thinking about thinking" of raising rates. Enter the return of LIBOR floors. Though the occurrence of these features ebbed as rates rose throughout 2017 and 2018, currently they flow. At present, 98% of outstanding loans in the index have a floor, two-thirds of which are set at 0. Note that this is distinct from having "no floor," as a 0% floor provides protection from negative rates. The remaining third are set around 1%, and these can provide a yield enhancement today.
Turning to CLOs, it's important to note that these structures serve as a large and historically stable investor base for loans. About 60% of corporate loans in existence are held by these structures, which in turn are owned by long-term institutional investors seeking tailored levels of risk and return. CLOs as a vehicle type have been well structured for decades — to be sure, recent Moody's data show that only 55 of more than 12,000 rated US CLO tranches have suffered a principal impairment since 1999. That's an incidence of less than one-half of 1%, cumulatively, over more than two decades. What's more, today's vintage of CLOs can offer meaningfully more credit support than those structured before the financial crisis. More often than not, we find that the headlines in this topic area offer hyperbole over substantive facts.
What we are watching: The global rally in capital markets is prompting cheers and bewilderment alike, as higher stock account values provide relief, albeit in the face of historically elevated valuations that are testing investor nerves. According to Bank of America Merrill Lynch's Global Fund Manager Survey for June, a record 78% of respondents believe the stock market is "overvalued" — the highest response since 1998.
Meanwhile in bonds, credit spreads across much of the investment-grade world have again approached their pre-COVID tights. Between low base rates and narrow spreads, the bond math underpinning much of fixed income today suggests low return prospects ahead. In other words, the typical "60/40" investor might be feeling a little uncomfortable right about now.
Of course, in between these two spheres are the credit markets. By definition, these are hybrids that sport features of both stocks and bonds: price moves that correlate with earnings (like stocks) and a significant portion of total return associated with coupon income (like bonds).
Final word: At present, we think our loan asset class is a bright spot on the investment stage. As reported in Eaton Vance's latest Weekly Market Monitor, loans have a lower average dollar price and higher yield to maturity than every other major bond asset class. A 3% to 7% allocation to loans offers the opportunity to amplify portfolio income, diversify rate-sensitive bonds and provide modest upside potential in the face of elevated asset values elsewhere.
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 strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness.