five-bullish-answers

INCOME

EATON VANCE

Looking beyond traditional sources of yield

Scott Page, CFA Co-Director of Floating-Rate Loans Portfolio Manager Craig Russ Co-Director of Floating-Rate Loans Portfolio Manager Christopher Remington Institutional Portfolio Manager Product & Portfolio Strategy

MAY 2015 TIMELY THINKING

Floating-rate loans: 5 bullish signals behind 5 bearish questions SUMMARY

Why loans now?

Why we believe five common concerns…

1. “What happened to my return in 2014?”

More than half of advisors surveyed (53%) say clients concerned about rising rates are now more likely to consider floating-rate investments.* See page 3 for how floating-rate loans can help. *Based on results from the Eaton Vance April 2015 Advisor Top-of-Mind Index.

2. “Why do I need loans? It doesn’t look like rates are going up any time soon.”

3. “I keep hearing about crazy leverage in deals.”

4. “I’m worried retail outflows will cause market disruptions.”

5. “I’ve heard that ‘covenant-lite’ loans can weaken credit quality.”

…support a bullish position for floating-rate loans.

At Eaton Vance, we value independent thinking. In our experience, clients benefit from a range of distinctive, strongly argued perspectives. That’s why we encourage our independent investment teams and strategists to share their views on pressing issues—even when they run counter to conventional wisdom or the opinions of other investment managers. Timely Thinking. Timeless Values.

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MAY 2015 TIMELY THINKING

5 BULLISH SIGNALS • 2

■■ Leverage

1. “ What happened to my return in 2014? The yield was about 5%, but my total return was just 1.6%.”

A growing risk aversion on the part of retail investors last year broadly affected credit risk sectors like floating-rate loans and high-yield bonds, as mutual funds for both sectors experienced net outflows. Floating-rate loan prices fell, partially offsetting income gains and reducing total return.

In our view, last year’s negative sentiment was at odds with the fundamental strengths of the floating-rate loan market in a broadly improving economy. We see three broad reasons for considering floating-rate loans in today’s environment: Strong fundamentals: ■■ Cash flow coverage is high.

At 4.4x, cash flow coverage of interest – the ability of an issuer to service its debt – is at its highest level in 10 years, over which it has averaged 3.2x (Exhibit A).

■■ Defaults

are way down.

For the trailing 12 months as of March 15, 2015, the number of defaults stands at 0.6% of issuers, compared with the 2.2% average of the past 10 years.2

Compelling valuations: ■■ Attractive yield.

Among U.S. sectors, the 5.2% yield on the S&P/LSTA Leveraged Loan Index3 (the S&P/LSTA Index) as of March 31, 2015, is second only to high yield.

■■ Spreads

are above median.

At 492 basis points (bps) above Libor, the spread of the S&P/LSTA Index is wider than the 10-year median of 484 basis points (bps). It’s modestly tighter than the 10-year average of 518 bps, but that stat is distorted by the financial crisis in which spreads were wider than 1,000 bps for seven months. And loans today offer substantially better value than the precrisis market, in which spreads averaged 347 bps above Libor from 2000 to 2007.

The ability of issuers to service debt has never been stronger.

14x

5x

11x

4x

8x

3x

5x

2x

2x

1Q05

1Q06

1Q07

1Q08

Total Enterprise Value (left scale)

1Q09

1Q10

Leverage (left scale)

1Q11

1Q12

1Q13

1Q14

4Q14

1x

EBITDA multiple of interest cost

Multiple of EBITDA

Exhibit A

has fallen.

At 5.7x, EBITDA1 is down from its recent peak of 6.9% in the third quarter of 2012, and below its 10-year average of 6.0x.

Cash flow interest coverage (right scale)

Sources: S&P Capital IQ LCD, FactSet, Eaton Vance, as of 12/31/14. Multiples are based on companies in the S&P/LSTA Leveraged Loan Index, an unmanaged index. Data are provided for informational purposes only. It is not possible to invest directly in an index. See page 7 for index definitions.

EBITDA stands for earnings before interest, taxes, depreciation and amortization, and is a common measure of corporate cash flow. 2The floating-rate loan trailing 12-month default rate, measured by assets, was 3.2% as of 12/31/14 – higher than the 10-year average of 2.6%. However, the current rate is skewed by the April 2014 default of Energy Future Holdings (EFH) – a large, highly leveraged deal dating to the pre-financial-crisis credit bubble. EFH, in our view, represents a unique situation unlikely to be repeated and comprised 2.5% of the loan market, according to S&P Capital IQ LCD. Without EFH, the assetweighted default rate as of 12/31/14 stood at 0.7% – near historical lows. 3The S&P/LSTA Leveraged Loan Index is an unmanaged index of the institutional leveraged loan market.

1

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MAY 2015 TIMELY THINKING

Exhibit B

5 BULLISH SIGNALS • 3

The market sees a flattening yield curve with a rising short end.

3.0% 2.5% 2.0% 1 year

2 year

3 year

1.5% 1.0% 0.5% 0.0%

3 mos.

6 mos.

1 yr.

2 yr.

3 yr.

4 yr.

5 yr.

10 yr.

15 yr.

30 yr.

US Treasury maturity Source: Bloomberg, LLC, as of March 15, 2015. Past performance is no guarantee of future results. Data are provided for informational purposes only.

A history of income-driven returns: ■■ Total return for floating-rate loans historically has been driven mostly by income. That helps explain why, since 2002, we have seen years with price losses followed by price gains three times: 2002-2003, 2008-2009 and 2011-2012. The 2008-2009 financial crisis was the biggest example.

Will 2015 also be a rebound year? Loans had a total return of 2.1% for the first quarter of 2015, based on the S&P/ LSTA Index – a pace well in excess of the 5% annual average for the 10 years ended March 31, 2015. We believe that fundamental, valuation and historical factors suggest that the rebound is warranted.

2. “ Why do I need loans? It doesn’t look like rates are going up any time soon.”

Regardless of how you believe the yield curve may change in 2015, we see floating-rate loans as a bright spot in any scenario. For example:

■■ No

change in curve.

The 5.2% yield on the S&P/LSTA Index as of March 31, 2015 was more than twice that of the Barclays U.S. Aggregate Index. Rates don’t have to rise for loans to be a valuable component of a fixed-income portfolio.

■■ Rates

rise at the short end.

This scenario has become increasingly likely in the U.S., as its economy has gained traction and the U.S. Federal Reserve has indicated its willingness to begin raising rates (Exhibit B). By definition, most floating-rate loan yields rise with Libor, which has been highly correlated with changes in the fed funds rate.4

■■ Rates

rise at the long end.

With central banks in Europe, Japan and China embarking on major monetary policy easing, we feel that low global long-term rates are likely to stay low and also keep long-term U.S. rates anchored. However (just in case), loans historically have been positively correlated with 10-year U.S. Treasury yields – i.e., they have had positive returns when long-term rates have risen.

The widespread use of Libor “floors” in the loan market will likely introduce a lag in the upward adjustment of loan rates once Libor rates start to rise, because the floors in such loans mean that investors are already being paid as if Libor were 100 bps.

4

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MAY 2015 TIMELY THINKING

5 BULLISH SIGNALS • 4

3. “ I keep hearing about crazy leverage in deals.”

become a smaller component of the capital structure.

This is a case where impressions are not supported by the facts. Leverage has actually trended down over the past couple of years, as measured by the asset-weighted S&P/ LSTA Index (Exhibit C). Just as importantly, the ability of issuers to service their debt – as measured by EBITDA coverage of interest costs as of March 31, 2015 – has never been stronger, according to S&P Capital IQ LCD. Total enterprise values have also increased, so debt has Exhibit C

It’s certainly possible that smaller deals have “pushed the envelope” in terms of leverage – demand for yield has been strong as economic growth has gained traction. In our view, this underscores the importance of active management in the floating-rate loan market. Metrics like debt multiples and cash flow coverage don’t tell the whole story – that requires in-depth, professional analysis of fundamental credit quality and relative value.

Leverage taken on by loan issuers has trended down over the past 3 years.

7.0x

Multiple of EBITDA

6.5x

6.0x

5.5x

5.0x

1Q05

1Q06

1Q07

1Q08

1Q09

1Q10

1Q11

1Q12

1Q13

1Q14

4Q14

Sources: S&P Capital IQ LCD, Eaton Vance, as of 12/31/14. Multiples are based on companies in the S&P/LSTA Leveraged Loan Index. Past performance is no guarantee of future results. It is not possible to invest directly in an index. Data are provided for informational purposes only. See page 7 for index definitions.

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MAY 2015 TIMELY THINKING

5 BULLISH SIGNALS • 5

4. “ I’m worried retail outflows will cause market disruptions.”

The experience of the past couple of years, with the largest net-flow swing in the history of the floating-rate loan market, should relieve any concern over the impact of retail-driven volatility. After $75 billion of retail inflows in 2013, investors pulled $23 billion out of floating-rate mutual funds in 2014. This outflow helped push prices down, resulting in a subpar total return of 1.6%. We would view this as a routine and temporary disappointment, not a disruption (and, in our view, not reflective of fundamentals – see section 1).

At the same time, the floating-rate loan market proved its resilience by accommodating these retail flows without a

Exhibit D

hiccup – the total outstanding universe grew by 21% to $832 billion in 2014. This resilience is possible because retail investors are a small component of demand for floating-rate loans – it remains predominantly an institutional market.

Exhibit D shows that 2013, when retail funds swelled to 25% of the market, was a relative outlier compared with retail’s average of 14% over the past 15 years. As of November 30, 2014, the retail component stood at 18% – about the same as the end of 2012. Volatility is common among retail investors, but the floating-rate loan market has demonstrated that it can absorb the inevitable, periodic changes in sentiment.

Retail funds have been a modest presence in the loan market – on average, just 14%.

100%

40%

20%

RETAIL

60%

INSTITUTIONAL

80%

0% 1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Sources: S&P Capital IQ LCD, Eaton Vance, as of 12/31/14. Data are provided for informational purposes only.

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2010

2011

2012

2013

2014

MAY 2015 TIMELY THINKING

5 BULLISH SIGNALS • 6

■■ Liquidity

5. “ I’ve heard that ‘covenant-lite’ loans can weaken credit quality.”

Covenant-lite loans are those that don’t require traditional maintenance tests for leverage or interest coverage; rather, they impose restrictions on a company’s ability to issue new debt.

The notion that covenant-lite loans are weaker in credit quality is the opposite of what we see in the market – they have consistently traded at a premium to traditional “covenant-full” issues (Exhibit E. From our experience, this is because traditional covenants are now usually reserved for less creditworthy issuers.

There are several reasons, in our opinion, that the market does not view covenant-lite loans as a source of concern: ■■ Covenant-lite

loans still contain bedrock creditor protections not found in other fixed-income sectors, like restrictions on paying dividends or taking on additional liens. Also, like covenant-full loans, they are senior in the capital structure and usually secured by specific assets.

Exhibit E

is a major source of investor protection. The liquidity in today’s $800 billion floating-rate loan market means investors can trade out of their positions if they are concerned about an issuer’s prospects. This wasn’t the case in the early days of the loan market, when banks typically had to hold loans to maturity – covenants were usually the only tools available to protect their interests.

■■ Covenants

are just one factor in credit analysis. Loan agreements typically run about 200 pages. Covenants, whether lite or full, need to be evaluated by a skilled professional in the context of an overall investment decision about fundamental credit quality and relative value.

It is not unreasonable to expect that traditional covenantfull loans will continue to recede and covenant-lite will dominate by a growing margin. We do not see this as a source of concern for investors, but as one more step in the evolution of loans into a full-fledged global capital market.

Measured by market pricing, covenant-lite loans are seen as stronger than covenant-full loans.

102

100

Weighted Average Bid

98

96 Covenant-lite

S&P/LSTA Index

94

92

90 Mar-12

Jun-12

Sep-12

Dec-12

Mar-13

Jun-13

Sep-13

Dec-13

Mar-14

Jun-14

Sep-14

Dec-14

Mar-15

Sources: S&P Capital IQ LCD and S&P/LSTA Leveraged Loan Index, as of March 15, 2015. Data are provided for informational purposes only. Covenant-lite is represented by the S&P/LSTA Leveraged Loan Covenant-lite Index. See page 7 for index definitions. It is not possible to invest directly in an index. Past performance is no guarantee of future results.

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MAY 2015 TIMELY THINKING

5 BULLISH SIGNALS • 7

Index Definitions The S&P/ LSTA Leveraged Loan Index is an unmanaged index of the institutional leveraged loan market.

The S&P/LSTA Leveraged Loan Covenant-lite Index is the covenant-lite subset of the S&P/LSTA Leveraged Loan Index.

Unless otherwise stated, index returns do not reflect the effect of any applicable sales charges, commissions, expenses, taxes or leverage, as applicable.

Important Information and Disclosure This material is presented for informational and illustrative purposes only as the views and opinions of Eaton Vance as of the date hereof. It should not be construed as investment advice, a recommendation to purchase or sell specific securities, or to adopt any particular investment strategy. This material has been prepared on the basis of publicly available information, internally developed data and other third party sources believed to be reliable. However, no assurances are provided regarding the reliability of such information and Eaton Vance has not sought to independently verify information taken from public and third-party sources. Any current investment views and opinions/analyses expressed constitute judgments as of the date of this material and are subject to change at any time without notice. Different views may be expressed based on different investment styles, objectives, opinions or philosophies. This material may contain statements that are not historical facts, referred to as forward-looking statements. Future results may differ significantly from those stated in forward-looking statements, depending on factors such as changes in securities or financial markets or general economic conditions. Actual portfolio holdings will vary for each client.

Investing entails risks and there can be no assurance that Eaton Vance, or its affiliates, will achieve profits or avoid incurring losses. It is not possible to invest directly in an index. Past performance is no guarantee of future results.

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MAY 2015 TIMELY THINKING

5 BULLISH SIGNALS • 8

About Risk 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. Investments rated below investment grade (typically referred to as “junk”) are generally subject to greater price volatility and illiquidity than higher-rated investments. Investments in foreign instruments or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical or other conditions. In emerging countries, these risks may be more significant. As interest rates rise, the value of certain income investments is likely to decline. Bank loans are subject to prepayment risk. 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. Convertible securities may react to changes in the value of the common stock into which they convert, and are thus subject to the risks of investing in equities. When interest rates rise, the value of preferred stocks will generally decline. Fund share values are sensitive to stock market volatility. A nondiversified fund may be subject to greater risk by investing in a smaller number of investments than a diversified fund. No Fund is a complete investment program and you may lose money investing in a Fund. The Fund may engage in other investment practices that may involve additional risks and you should review the Fund prospectus for a complete description.

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