Eaton Vance
December 15, 2016
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Fed delivers continued tailwind for floating-rate loan investors

Scott H. Page and Craig P. Russ, Co-Directors of Bank Loans

Boston - The Federal Reserve is now "two-for-two" in back-to-back December rate hikes. For floating-rate loans, higher income may lie ahead for this adjustable-coupon asset class, but loan investors' wait will continue - at least for a little while longer.

Yet, the delay mechanism of Libor "floors" - and more recently, issuer adoption of 1-month versus 3-month base-rate terms - have by and large run their course. Room to hide has all but run out for loan issuers looking to evade paying more. The game is up, and this means the wait for higher loan yields is nearly over.

Here's why: Nearly all loans today include a so-called Libor floor, a minimum base rate that's paid regardless of real-world short-term rates (Libor stands for the London Interbank Offered Rate, a widely-used global benchmark for short-term interest rates). The average floor in today's loan market is about 0.98%, based on the S&P;/LSTA Leveraged Loan Index. That compares with actual 1-month and 3-month Libor of 0.65% and 0.95%, respectively.

Even if issuers continue the recent trend of 1-month-term adoption, today's Fed rate hike lifts even the shorter of the Libor rates to approximate parity with loan market floors.

What does it all mean? Floors notwithstanding, even now investors may benefit from a small bump in coupons. To be sure, about 10% of the loan market is "floorless," while elsewhere some limited portion of 3-month adopters - today about two-thirds of the loan market - may choose to stay the course rather than bother with rolling down to the shorter and somewhat cheaper 1-month option. Whatever little immediate lift there may be right now, it will be ever so modest, and it will also take a month or two to trickle into investment-product distribution rates.

With this rate hike now in the books however, the outlook for coupon adjustments ahead is brighter, as loans should have a much more "one-for-one" relationship with Fed hikes beginning with the very next one, and of course all those that follow. Discussions of base rates, Libor floors and parity should all ultimately fade - finally.

Floating-rate loans should return to their longstanding historical character as an asset class that benefits bond portfolios in a rising-rate environment, driven by two principal forces. First, unlike fixed-rate bonds, loans have a floating rate that resets periodically, and the absence of duration provides protection against rising interest rates. Second, rising coupons have been accretive to performance the more that short-term rates rise. For example, loans performed well in the tough bond years of 1994, 1999 and 2004-2006. Though today's circumstances are different - they always are - hard lessons from yesteryear's bond market troubles are indeed relevant today.

Bottom line: With a yield-to-maturity of 5.4% for the S&P;/LSTA Leveraged Loan Index, a duration measured in days (as opposed to years) and higher short-term rates expected ahead, the base case "math" of this asset class is positive. Stretched asset class valuations elsewhere and Janet Yellen's comments about the Fed's intentions are additional tailwinds. That's why we believe investors should consider floating-rate loans when positioning bond portfolios for 2017.

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. Purchases and sales of bank loans in the secondary market generally are subject to contractual restrictions and may be subject to extended settlement periods. 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. 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.

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