We spoke with the Eaton Vance investment team to discuss the current state and outlook on Bank Loans. Highlights from the discussion include the market’s fundamentals, the Fed’s rising rate policy and how bank loans have been impacted by the CLO market and underlying covenants.
SAA: The Fed’s rising rate policy now seems firmly on track. How are loans participating in those increases?
EV: Libor, which tracks the fed funds rate very closely, gained 135 basis points (bps) from the start of 2017 through mid-April, and that has been pushing loan distributions higher. Since the start of 2017, the credit spread over Libor has tightened by about 60 bps, reflecting the strong demand for loans relative to supply and a large refinancing wave of issuers. The tightening credit spread offset some of the increase in Libor, but distributions are still starting to increase.
To give some historical context, the market is starting to look similar to the 2004 environment: Yields grind higher, accompanied by a slight contraction in the credit spread. Both then and now, the trajectory of Libor increases is steeper than the tightening increments in the spread. Between March 2004 and June 2006, the loan coupon rate increased by 369 bps while the credit spread tightened by 67 bps. Over the same period, the S&P/LSTA Leveraged Loan Index returned 13.0% compared with 4.8% for the Bloomberg Barclays U.S. Aggregate Index.
SAA: How are the market’s fundamentals holding up? How have bank loans been impacted by changes in the CLO market?
EV: Fundamental conditions still remain fine. We don’t see any major problems looming around the corner at this point. The default rate, through quarter-end, did edge up to 2.4% on a trailing 12-month1 basis from 2.1%, principally due to iHeart Communications’ bankruptcy – an event that everybody knew was coming. We expected a few more headlines, given that it notched up the global default rate by 14%. One story noted it as the fifth-largest default, including an exclamation point at the end of the sentence. But generally, investors took it in stride, and it’s still priced into the market as a whole.
As of mid-April, S&P/LSTA Leveraged Loan Index had about 1.8% in default, and the loan market manager forecast for next year is about 2.4%. Based on our watch list, we think it could potentially be lower, but directionally, we are in agreement with the market – there’s not much of a shift in the default scenario going forward. Trading indicators align with our assessment as well. One example is the distress ratio – the share of the market trading below $80 – which enters the second quarter at 1.6%.
While the default picture is benign, we think it is fair to say that we are closer to the end of the credit cycle than the beginning. We believe the credit cycle still has a little bit more room to run, but prudence is definitely the way to go. Leverage is creeping up a little bit, but interest and fixed charge coverage remains near recent highs. We always look at deals on a case-by-case basis, and are fairly selective – we pass on about 70% of deals that we see in the marketplace. Loans are not an asset class that lends itself to passive investing.
One regulatory development worthy of note. You may recall risk retention rules for CLOs under the Volcker Rule, which required managers to tie up capital through continued ownership of CLOs they offered. The Loan Syndication & Trading Association (LSTA) sued to exclude CLOs from the Volcker Rule, and the litigation was successful. The government chose not to appeal, so the Volcker Rule no longer applies to U.S. loans.
However, it’s hard to see how the ruling is going to have much of an impact, given how strong demand has been over the past two years. It isn’t clear the rule ever put a crimp in CLO production, so we believe it is not likely that its removal will have any positive effect. But the ruling does remove one potential artificial constraint on the market, in theory anyway.
SAA: How have bank loans been impacted by the general loosening in underlying covenants, including the increasing presence of ‘covenant-lite’ loans?
EV: Covenant-lite issuance is the new normal for loans, and the implication is that this development has introduced significantly greater risk for the loan investor. The reality is quite different. Covenant-lite loans are indeed senior, secured, first-lien term loans. They are loaded with covenants, both affirmative as well as negative.
Importantly, what makes a covenant-lite loan different from a fully covenanted loan is the absence of “maintenance tests,” or lines in the sand that require issuers to maintain certain financial ratios over time. Maintenance tests trace themselves from the early days of the loan market some 25 years ago. They were absolutely necessary given the small and closely held nature of the asset class. That’s slowly but surely been changing as the market has grown over the past decade.
Today’s market is large (more than $1 trillion in par outstanding globally), widely subscribed (more than 300 investor groups) and offering robust liquidity (more than $600 billion in loan trading annually). If managers no longer like a credit, they simply sell it. The fact that no other asset class offers maintenance tests seems pertinent as well. These were exclusively a loan market “extra.” Generally, neither high-yield nor investment-grade bonds have them.
Finally, covenant-lite doesn’t imply anything at all about the actual underlying fundamental credit risks. That is, covenant-lite doesn’t in itself mean issuers have higher leverage, lower interest coverage or anything else. Our observation is that these important credit factors have by and large remained stable in keeping with the long-term character of the asset class.
SAA: How would you characterize the market’s technical condition?
EV: It’s a pretty balanced market in terms of supply and demand. There’s not a lot of visibility out more than a couple of months in terms of supply, but for now it looks like we’re in a pretty healthy dynamic. What we are seeing is definitely a little more M&A and LBO activity, and not quite as many private equity-to-private equity deals as there were last year. The pickup in supply is a good thing, in our view, given that demand still remains strong.
SAA: Could you summarize your outlook for the balance of the year?
EV: We remain constructive on the asset class’s current credit risk profile. Issuance over the past year has allowed maturities to be extended, with most occurring in 2020 and 2021. Maturity extension means a reduction in refinancing risk that benefits both issuers and loan investors.
Credit statistics remain in check from a historical perspective, while recession risks appear low for now. We believe that in this environment, defaults will likely be limited to individual situations rather than a broad-based wave.
With prices entering the second quarter near par, there’s little to expect in terms of market value appreciation for loans. However, if the Fed continues its tightening policy, loans have the potential to deliver higher income and greater total return as well. For investors with exposure to long-duration bonds, we believe this is an excellent time to consider the diversification potential that loans can offer.
1Source: S&P/LCD and S&P/LSTA Leveraged Loan Index, 3/31/2018.
Bloomberg Barclays U.S. Aggregate Index is an unmanaged index of domestic investment-grade bonds, including corporate, government and mortgage-backed securities. Standard & Poor’s 500 Index is an unmanaged index of large-cap stocks commonly used as a measure of U.S. stock market performance. S&P/LSTA Leveraged Loan Index is an unmanaged index of the institutional leveraged loan market.
The views expressed 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. Investing entails risks and there can be no assurance that Eaton Vance, or its affiliates, will achieve profits or avoid incurring losses. Past performance does not predict future results.
©2018 Eaton Vance Management
Source: Strategic Asset Alliance, Eaton Vance Management
The information contained herein has been obtained from sources believed to be reliable, but the accuracy of information cannot be guaranteed.