Powell's pause and the potential positives for loans

August 23, 2019 — In this Q&A, the Eaton Vance floating-rate loan team offers its perspective on today’s loan market.

By: Craig P. Russ; Andrew Sveen, CFA; Ralph Hinckley, CFA; Christopher Remington

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By Craig P. RussCo-Director of Floating-Rate Loans, Eaton Vance Management and Andrew SveenCo-Director of Floating-Rate Loans, Eaton Vance Management

Boston - It's a bird, it's a plane. Nope, it's just a dove.

Inasmuch as "nothing happened" at March's Federal Open Market Committee (FOMC) meeting -- the Fed neither raised nor lowered its policy rate -- market expectations for a dovish message were indeed met, perhaps even exceeded. As an extension of this, investors and commentators alike are waxing on about what it means, and we might as well join the fun. After all, our particular asset class (floating-rate loans) is so frequently thought about in the context of "that thing to own when rates are rising." With the Federal Reserve led by Jerome Powell on pause, now what?

To keep this post both pithy and compartmentalized, here we share a topical list of recent discussion areas related to the Fed, the economy and our asset class. In short, it's a list of FAQs that we've received subsequent to the latest Fed announcement, and our thoughts on each:

1. "Does the Fed's pause make you nervous about the economic backdrop for loans?"

In a word, no.

To quote Chairman Powell's opening remarks:

"My colleagues and I have one overarching goal: to sustain the economic expansion, with a strong job market and stable prices, for the benefit of the American people. The U.S. economy is in a good place, and we will continue to use our monetary policy tools to help keep it there. The jobs market is strong, showing healthier wage gains and prompting many people to join or remain in the workforce. The unemployment rate is near historic lows, and inflation remains near our 2 percent goal. We continue to expect that the American economy will grow at a solid pace in 2019, although likely slower than the very strong pace of 2018."

Our take: The U.S. is indeed enjoying a broadly supportive fundamental backdrop, and the Fed's commentary is consistent with our view that credit markets should benefit from a healthy, albeit modestly slower, growth environment ahead. This is generally not the type of environment in which we would expect a meaningful uptick in corporate defaults. In fact, U.S. corporate credit tends to perform just fine in a low-GDP environment. Not too hot, not too cool.

2. "If short-term rates aren't rising, will that impede return potential in the asset class?"

Probably not. Loan coupons float over a combination of 1-month and 3-month LIBOR, and both of these track closely with the Fed's policy rate. A Fed on pause merely suggests that today's loan market base rates are expected to remain stable, not move lower. In fact, the Fed's latest "dot plot" shows more rate hikes ahead, albeit they are now expected in 2020 versus this year. That means that today's current income levels -- distribution rates on loan mutual funds range around 5-5.5% today -- are likely to prevail for the time being, though it appears they could still rise modestly next year if the projected rate hikes materialize.

Meantime, it's unlikely to see much in the way of spread compression either -- spreads are the other component of loan yields -- as the discounted average dollar price of the loan market is a natural regulator on refinancings, and should help keep new-issue yields competitive as well. In fact, new-issue spreads over LIBOR have grown a little more generous recently, according to data from S&P's Leveraged Commentary & Data (LCD). What's more, today's discounts can be accretive to forward total returns, as many loans outstanding are expected to ultimately accrete to par.

Consider, the yield to maturity (YTM) of the S&P/LSTA Leveraged Loan Index is approximately 6.7% as of March 22, closely comparable to what's on offer in the high-yield bond market. To us, the loan market is signaling value.

3. "The yield curve is exceptionally flat, with parts of the curve now inverted. Does this signal near-term recession risks?"

It's often half-joked that a flat or inverted yield curve has predicted 10 of the last five recessions, or something along these lines. The circumstances always matter. Regardless of the precise shape of the yield curve, the U.S. economy remains strong -- a bright spot on the global stage, in fact.

Modestly less strong growth may be expected ahead, and this is generally a function of the waterfall effect of the slowdowns in other parts of the world, mainly Europe as well as China. That said, our asset class is principally a U.S.-centric one. Away from this detail, we think investors should be mindful not to miss the forest for the trees: If you are truly concerned about a U.S. recession, selling equities and increasing safety exposures is usually the first-order place to start. If you are not so concerned about recession to the point of reducing equities, cutting second- or third-order credit products seems a bit non-sequitur (to us), especially the senior/secured kind like loans, as these have shown over time to be much more recession-proof in comparison.

4. "Even if the U.S. economy is fine for now, there will be a downturn eventually. What then?"

Of course there will be a downturn eventually. Neither the economic clock nor the business cycle have been repealed. Recession will come again someday, and with it will come rising defaults. Yes, the "D" word.

But doing the math on this is important, as well as comforting. Take for example the long-term average default rate and the long-term average recovery rate for this market: The S&P/LSTA Leveraged Loan Index has a since-inception average default rate of 2.95% per annum; meantime the various credit rating agencies put long-term recoveries in the 70%-80% range. Taken together, this data points to a 60-90 basis point annualized credit loss through time.

Now compare that to income generation of 500-600 basis points annualized and it's fairly easy to see why loans tend to have a strong propensity for positive returns through time. Think about it. Income generation represents the majority of the return contribution; credit losses the minority. And since income by definition cannot be negative, long-term loan performance is consistently skewed toward the desired side of zero.

"Stop," you may say. "Don't tell me about 'averages'...what about the downturns?" Fair enough. Take the granddaddy of all recessions, the global financial crisis. The cumulative default rate of the S&P/LSTA Leveraged Loan Index was 15% for the years 2008, 2009 and 2010 combined. Ultimate recoveries were in the aforementioned 70-80% range. Including coupon income, the annualized total return through that tumultuous three-year period was a positive 5-6%. Repeat: Positive 5-6%, annualized. Granted, the "ride" was no fun, but when all was said and done, the ultimate results were similar to those of the rest of the loan market's history. Most would probably agree 2008 was an outlier. Of the 30 years we've managed assets in this space, there has been only a single other negative year: 2015. The S&P/LSTA Leveraged Loan Index returned -0.69% that year.

5. "Are there other implications of a Fed on pause?"

There always are, but most of what's important is covered above. Despite three years of policy rate hikes, the Fed's monetary policy continues to remain very accommodative. Real interest rates remain close to zero. The Fed appears intent on keeping the good times rolling, while being mindful about the potential for asset bubbles or other unintended consequences.

Thus "the pause," which we welcome. When it comes to the economy, many like to ask about baseball innings. "What inning are we in now?" But as a popular strategist we follow likes to say, "innings have no time clocks." This cycle may be long in age, but time in itself doesn't put an end to things. Remember, market timing has never proven to work, so we doubt that now is a good time to start. By contrast, maintaining well-balanced and diversified portfolios is always a good idea. Aside from generating income, bonds can also help diversify stock portfolios. And floating-rate assets can help to diversify your bonds.

Bottom line: Starting yield has historically shown to be a reliable forward gauge of return potential for floating-rate loans. The YTM of the S&P/LSTA Leveraged Loan Index is 6.7%. Loans also offer a senior/secured credit profile and the absence of bond duration. Putting it all together, we believe loans are attractive and that Powell's pause hasn't changed that.

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.