Starting yields historically have been reliable guides to future returns. By that measure, floating-rate loans should draw attention, both in comparison with other fixed-income sectors and relative to their own history. For example, the chart below shows how the yield on loans has recently moved higher than high-yield bonds, reversing their typical relationship. As of August 31, 2019, the yield on loans was 6.7%, based on the S&P/LSTA Leveraged Loan Index, compared with the 5.9% yield on the ICE/BofAML US High Yield Index. By way of comparison, the benchmark Bloomberg Barclays U.S. Aggregate Index is yielding 2.1%.
Loan yields are also higher than those of emerging-markets debt - again reversing the typical relationship. Keep in mind that with loans, there aren't the currency or political risks of emerging markets debt, and relative to high-yield, loans are senior in the capital structure and secured. The yield on loans today is also historically high, relative to their long-term average total return - about 6.7% to 4.9%, or a 180-bps advantage.
What's behind the rise in loan yields? A key factor is the inverted yield curve. Loans are generally priced off of 1-month Libor, which yielded 2.09% on August 31, 2019, while high-yield bonds are priced off comparable-maturity U.S. Treasury bonds. As of August 31, 2019, both the 10-year U.S. Treasury (yielding 1.50%) and the 5-year U.S. Treasury (yielding 1.39%) had yields lower than Libor. So in the unusual environment of an inverted yield curve, loans were being priced off of a higher-yielding benchmark than high-yield bonds - that's a big factor in the atypical loan/bond spread.
Negative retail sentiment is also keeping yields higher than normal. Loans have experienced large net outflows from the retail sector - more than $20 billion this year, following $18 billion in December 2018, which puts upward pressure on loan yields. The net outflows have helped push the market price of the S&P/LSTA Leveraged Loan Index to 96, while other fixed-income sectors are trading above par, or just under.
Most of this negative sentiment is predicated on the common belief that floating-rate loans must underperform in a falling-rate environment - a misconception we'll address in a subsequent blog. Retail loan investors represent approximately 10% of the market, but at times (like these) can have an inordinate impact on loan prices.
Bottom line: Investors who equate falling rates and Fed accommodative policy with subpar loan performance should take a closer look at today's yields. It's also instructive to review loans' history in falling-rate environments - something we'll do in the next blog.
Andrew Sveen, co-director of Bank Loans, Eaton Vance
Sometimes referred to as the ‘biggest manager you have never heard of’, Jonathan Boyd has caught up with PGIM for insight into its Europe region developments as part of global expansion