It’s times like these, as stocks tumble and conventional bonds offer insufficient yield to cushion the fall, when investors get the urge to think differently about how to generate returns while protecting their money. One such non-traditional asset class comprises floating-rate loans, which offer the potential for above-average yields and non-correlation to stocks and bonds.
Floating-rate loans are corporate debt issued by below-investment-grade companies. Also known as bank loans, leveraged loans or senior loans, the coupon income on these loans adjust regularly to maintain a fixed spread over a variable base rate of short-term interest rates. For years, that base rate was tied to LIBOR, or the London Interbank Offered Rate. But that’s being phased out and replaced by the Secured Overnight Financing Rate, or SOFR.
The LIBOR-to-SOFR transfer is a behind-the-scenes affair that appears to be going smoothly. But what retail investors care more about is how floating-rate loans can work for them, and the easiest way to access these securities is through packaged products such as mutual funds or exchange-traded funds. One such product is the Eaton Vance Floating-Rate Fund, which has generated above-category returns since it launched in early 2001.
Eaton Vance, which was acquired by Morgan Stanley last year, offered its first floating-rate fund in 1989 and claims to be the longest-tenured player in this space. As of January 31, the fund’s portfolio consisted of securities from roughly 535 issuers across 37 industries. There were a sprinkling of corporate bonds, other assets and cash, but the vast majority of holdings (86%) were floating-rate loans.
The average duration of the fund’s holdings was 0.35 years as of January 31. Duration is a measure of a debt instrument’s sensitivity to changes in interest rates, and the fund’s very low duration rate should buffer it against volatility when the Federal Reserve starts its expected campaign to raise the federal funds rate multiple times this year—and possibly into next year—in the fight against inflation.
The recent average coupon on the underlying loan portfolio was 4.14%, while its distribution rate (the dividend payout rate to shareholders that accounts for fees, cash drag and the like) was 3.21% as of March 9.
According to Eaton Vance, the yields on floating-rate loans are only slightly less than those offered by high-yield bonds, but with significantly less duration risk (according to a comparison of the S&P/LSTA Leveraged Loan Index with the Bloomberg U.S. Corporate High Yield Index, as of December 31, 2021).
“This is an income product that should be looked at as a steady provider of consistent income,” says Andrew Sveen, a portfolio manager of the Eaton Vance Floating-Rate Fund. “Second, it’s a floating-rate product that floats off of LIBOR, and increasingly off of SOFR. Whether it’s LIBOR or SOFR, that base rate is tied closely to the federal funds rate. As short-term rates move, you’ll see an increase on the yield and the payout on this fund, which makes a floating-rate fund very timely right now.”
He also notes the fund offers principal protection by investing in senior secured corporate loans that are supported by collateral and generally have the highest priority of claims in an issuer’s capital structure.
And while these are non-investment-grade loans, they are tied to “very large issuers with average revenue in the billions,” Sveen explains. “But sometimes things go awry, and in those rare cases when a company defaults the recovery on these loans tend to be very strong in the 70%-plus range. From a fundamental standpoint, principal protection is strong in this asset class.”
He adds that he and his team aim to protect against downside risk through fundamental, bottom-up credit analysis and portfolio diversification. According to Morningstar, the Floating-Rate Fund has a lower standard deviation and downside capture ratio than the bank-loan category as a whole.
Sveen’s team includes Ralph Hinckley and Jake Lemle, both longtime Eaton Vance loan analysts who came on board as co-managers in 2021. It also includes a sizable staff of 15 credit analysts.