Leveraged-Loan Lifers Battle the Negative Tide
(Bloomberg Opinion) -- Scott Page and Craig Russ are frustrated. Very frustrated. But not for the reason you might think.
Together they manage the $10 billion Eaton Vance Floating-Rate Advantage Fund, which invests in leveraged loans and traces its roots to 1989, making it the longest running of its kind. It could do no wrong for the first three quarters of 2018, gaining each month in an otherwise down year for fixed income. What’s more, it outpaced almost all competitors, mirroring its five-year track record of besting 97 percent of peers, according to data compiled by Bloomberg.
The good times didn’t last. The $1.3 trillion U.S. leveraged-loan market has since been pummeled week after week by investor withdrawals, including a record $3.3 billion in the period through Dec. 19. Eaton Vance, with some of the largest funds, was hardly immune to the selling. Page and Russ are narrowly holding on to a positive return for 2018. Some of their competitors haven’t been so fortunate.
That’s not what bothers them, though. That’s just “the market being the market,” they say, after a year in which investors were throwing money at leveraged loans hand over fist. No, what irks them can be summarized by a simple Google search of “leveraged loan warnings.” Who’s sounding the alarm? Just to name a few: Former Federal Reserve Chair Janet Yellen; current Fed officials; the International Monetary Fund; the Bank for International Settlements; the Office of the Comptroller of the Currency; Moody’s Investors Service; Senator Elizabeth Warren of Massachusetts; Oaktree Capital Group’s Howard Marks; and BlackRock Inc., the world’s largest money manager.
From their perspective, leveraged loans (and corporate credit in general) are unfairly picked on by those seeking the next financial crisis. They may have a point. Just to pick three Bloomberg headlines from the past few weeks: “Leveraged Loans Are Looking ‘Scary’ to These Money Managers”; “In Private Credit Frenzy, Main Street Gets Hooked on Leverage”; and “Corporate Debt Crises Could Come Faster and Harder in 2019.”
“Whatever it is about leveraged lending, there’s this whole sort of nomenclature around the asset class that lends itself to panic and fits, both positive and negative,” Page said. “Credit standards, for example, don’t just weaken — they deteriorate.”
“We’ve always had this gigantic cushion of protection,” he added, saying that while lending on average has increased to $440 million from $400 million, it’s all backed by $1 billion of collateral, which is far from extreme. “No matter how hard we try to portray that, you end up sounding defensive.”
Page, who is 59, has a deep background in leveraged loans. He joined Eaton Vance’s floating-rate loan group in 1989, when the fund was just getting off the ground as the Prime Rate Reserves Fund. He was so struck by the concept while working at Dartmouth College’s investment office, he says, that he wrote a letter to Dozier Gardner, the president of Eaton Vance at the time. It wasn’t long before he was brought on board.
The 55-year-old Russ, who began at Eaton Vance eight years later, is equally a leveraged-loan lifer. He previously worked in commercial lending at State Street Bank and just a few years ago was selected as chairman of the board of directors of the Loan Syndications and Trading Association. He and Page have managed the current iteration of the fund since its inception in 2008.
Not surprisingly, the two see bright days ahead for leveraged loans. Investors should expect returns in excess of 6 percent in 2019, they say, with the caveat that fund outflows need to stop first. They admit there’s no easy way to estimate when that might happen. Recent history has suggested that things get a bit worse after $2 billion of withdrawals before they get better.
In a way, the bullish case is easier to make now than it was just a few months ago. Between the litany of voices speaking out against the debt and the general risk-off mood in the final months of 2018, leveraged loans have plunged. The average price in the market, as measured by the S&P/LSTA Leveraged Loan Index, tumbled to 94.5 cents on the dollar on Dec. 20, the lowest in more than two years, after spending almost all of 2018 between 98 and 99 cents. November was the worst month for the Eaton Vance fund since December 2015.
“The biggest complaint on our market a couple months ago was that it was too hot,” Russ said. “As we look out into 2019, I can almost guarantee you the loans are going to be less levered, we’re going to have more teeth in our credit documents and the spreads are going to be wider. It’s become a buyers’ market now, and that’s a good thing for managers and investors.”
Now, the pullback probably shouldn’t be shrugged off so easily. Just ask lenders like Wells Fargo & Co., Barclays Plc and Goldman Sachs Group Inc., which have taken the rare step of holding on to loans they’ve underwritten but not yet sold to investors. Sales of collateralized loan obligations have also dropped in recent months, removing a core buyer in the market. The Fed may have to pause its interest-rate increases because of volatility across risk assets, which limits — but doesn’t erase — the appeal of leveraged loans as as hedge. When the credit cycle truly turns south, Moody’s expects lower recovery rates than in 2008, for several reasons. It’s not as if the selling was completely without merit.
One bright spot in the recent decline, apart from cheaper prices, is that it gave managers like Eaton Vance a chance to prove that the market isn’t as illiquid as feared by those who evoke the specter of archaic fax machines preventing investors from getting their money back. Yes, the settlement process takes days, which feels like ages in the era of electronic trading. But, according to Page and Russ, they had no issues offloading their holdings during the recent bout of turbulence. The market has fallen for weeks on end, but it has never really “gapped” lower, which would signal that buyers disappeared entirely.
Page and Russ know they can only do so much to stem the negative tide. But they’re convinced it’s just a matter of time before leveraged loans bounce back, as they have time and again in the post-crisis era. The economy is still strong, they say, and even if the Fed takes a break from raising rates, yields are already tough to beat. The vast majority of loans are paid back in full, they insist, and the fraction that don’t still recover enough that current prices are too low.
Some will surely write them off as talking their book. Nevertheless, the two are as confident as ever that their fund’s 30th birthday next year will be a happy one.
“We have to stick with the facts,” Page said. “We are not seeing evidence of credit risk shifting at a magnitude that’s been implied by this price. The more you try to say it’s not there, the more people are convinced it is there. My impulse is just to stay quiet.”
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.
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