Q&A with John Redding: Portfolio Manager, Eaton Vance Floating-Rate Loans February 2019

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Bank loans got a bad wrap in the global financial crisis due to their association with collateralised debt obligations (CDOs) which, in effect, were responsible for the crisis. However, bank loans can actually provide good diversification within portfolios. Industry Moves speaks with Eaton Vance’s John Redding – portfolio manager for the group’s Floating-Rate Loan Team - about their role as “the zig for the common zags” found elsewhere in portfolios. He also shares some sage advice from his mother.

How do you see the outlook for US floating-rate loans at this point in the cycle?

By way of an update, the US loan market rallied strongly at the start of 2019 and has recovered about half of the approximately 4 percentage point decline in prices which occurred in the final quarter of 2018. As at 28 January 2019, the weighted average bid price for the S&P/LSTA Leveraged Loan Index was 95.90 percent of par.

There is some potential for further price appreciation from here and we could see a slow grind toward par if the economy and financial markets experience reasonable stability. For the time being, uncertainties around international trade are not helping provide that stability, and the same goes for the political standoff in Washington with the government shutdown. While the likelihood of rising interest rates is lower than in early December, there is still a chance for modest rate rises in 2019 which would benefit floating rate loans. With a mid-single digit yield, projected total returns for loans look reasonably attractive.

You mentioned the rebound of US loans in January after the sell-off in the fourth quarter of 2018. What is the reason for the rebound?

Loans are a unique asset class that historically do well to diversify portfolios. They are the zig for the common zags prevalent elsewhere in client portfolios. Although loans can periodically prove frustrating – such as occurred during Q4 of 2018 – rebounds tend to be quick and relatively V-shaped. Among the reasons for this are loans' short average life and senior/secured profile in the capital structure.

Historically, forward returns from depressed levels have been some of the asset class' best. In 2011, for example, Ben Bernanke introduced his zero interest rate policy and loan market returned just 1.5% for the year. In 2012 though, the market delivered a 9.7% return. Another example is the 2015/2016 period. In 2015, loans were down 0.7% amid worries surrounding commodities. In 2016, the market was up 10%. Past performance guarantees nothing, but the pull-to-par nature of this market hasn't failed yet.

Recent volatility in the US bank loan market has been attributed largely to outflows from US retail investors. What threat does the volatility of flows from retail investors pose to the market?

Retail loan funds can tilt the supply/demand balance, as happened in the fourth quarter. However, the impact of retail flows tends to be short-lived. This is because retail funds represent a small market segment – roughly 12% of outstandings – with the majority of the investor base being institutional investors, who generally have a buy-and-hold, strategic mindset. As at 28 January 2019, retail outflows have reduced from their peak.

It is also important to note that outflows were handled well during the fourth quarter of 2018. During this period, one worry related to outflows centred on the settlement period for loans and how that could interact with redemptions. However, this proved not to be an issue.

Looking ahead, we could see volatility of flows increase again, and market participants will need to respond. From a liquidity perspective, this means there also need to be buyers. That said, the fact that the market has a diversified investor base, much of which has long-term tied up funding, is a supportive factor.

How have bank loans typically performed in a rising interest rate environment?

The short answer is quite well, especially compared to fixed rate instruments. 2018 was the latest such period and although loans were hit hard in the fourth quarter – returning -0.03% in October, -0.90% in November and -2.54% in December – they generated a modest but positive return for the full calendar year (+0.44%). Most fixed rate alternatives posted negative returns for the year.

In terms of total returns, what can Australian investors expect from the US bank loan market in 2019?

We estimate that Australian investors should get a yield in excess of 5%. Any price appreciation would add to that.

Super funds are looking to diversify away from a home country bias. What specific advantages can Aussie investors capture by investing in US bank loans in addition to, or instead of, Aussie bank loans?

Some investment ideas revolve around untested, perceived opportunities in a certain market. The US loan market is a well-developed, large and mature capital market for corporate borrowers. The market totals over US$1.1 trillion and has a 30-year track record. Transparency is aided by public information for both risk (debt ratings, defaults, recoveries) and reward (returns) throughout this period. And participation by multiple types of investors leads to reasonable liquidity, especially for larger loans in the market.

Some observers have drawn parallels between collateralised debt obligations (CDOs), which cratered in the financial crisis, and collateralised loan obligations (CLOs), which are a mainstay of the bank loan market. Can you address this?

Yes – CLOs are a subset of the more general term CDOs. The CDOs associated with the 2008 financial crisis had residential housing loans as their underlying collateral. CLOs are entirely different and have corporate loans as their foundation. It’s also important to note that CLOs are not a new creation: They were plentiful in 2008 and performed quite well even with an increase in corporate defaults. Yes, CLO tranches have more price volatility and less liquidity than an average leveraged loan, but they are well structured vehicles with long-term financing (as opposed to short-term, market value-based financing).

In July 2017, plans were announced to phase out Libor, which serves as a base-rate benchmark for more than US$1 trillion worth of floating-rate loans. What impact, if any, is this likely to have on the loan market?

A transition to a new benchmark will be needed. New benchmarks have been created and are in their early days of market involvement. This is obviously an issue for not just the loan market, but a much wider portion of the income markets. Market participants in multiple credit markets are actively working toward solutions, and the Loan Syndications and Trading Association (LSTA), the loan market’s very effective trade organisation, is spearheading the market’s efforts.

"Our 30-year involvement in this 30-year-old asset class, with group heads, portfolio managers and analysts who have worked together for a long time, provides a long term perspective on the loan market, asset selection and portfolio management.

Eaton Vance’s bank loans franchise has grown to around A$62 billion (US$45 billion). What differentiates your investment approach and do you think your approach is suited to where we are currently in the cycle?

Our 30-year involvement in this 30-year-old asset class, with group heads, portfolio managers and analysts who have worked together for a long time, provides a long term perspective on the loan market, asset selection and portfolio management. We’ve consistently emphasised fundamental credit analysis which has provided solid risk-adjusted returns for many types of investors over our 30-year history, and which leads to a predictability of style and performance results. While much of our approach is long-term, through-the-cycle oriented, I think it is very well suited if we’re in the later stages of an economic cycle. As a general notion, our slightly conservative style produces more downside protection.

What lead you into a career in finance?

Hopefully this doesn’t sound too strange, but I have always been interested in money. As a child, I collected coins and, somehow, that led to an interest in Wall Street. At university, I had a course in municipal finance and my professor assisted with getting my first job thereafter.

What has been the best advice that has helped you in your life and career?

My mother’s advice to read has certainly been something I have retained and for which I am very grateful. And I think the advice that one’s vocation in life supersedes one’s career has also been notable.

What is something that most people don’t know about you?

Although I am generally politically conservative, I have always been a staunch defender of the environment. I live on Cape Cod where we’re abundantly blessed with the beauty of nature. One recent volunteer opportunity was with the Audubon Society, which co-ordinates the rescue of cold-stunned sea turtles that get trapped in Cape Cod Bay when water temperatures decline. When you’re walking along a cold, windy beach in late November at 4am, it is tempting to question why you are doing this. But later, when you’ve helped rescue some of these endangered creatures as they wash ashore at high tide, you feel a great sense of satisfaction.

John Redding will be visiting Australia from February 11 - 15 and will be speaking at the Chief Investment Officer's Symposium

View John Redding's profile Read more about the Eaton Vance - Floating-Rate Loan Chart Book - Q4 2018