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By Sumit Desai, CFA | 06-20-2014 10:00 AM

Bank-Loan Excitement Fading, but Should You Be Concerned?

Investors in bank-loan funds shouldn't have to worry about a drop in prices as the loans are almost always paid back at par value and spreads are at median historical levels, says Eaton Vance's Scott Page.

Sumit Desai: Hi, I'm Sumit Desai, fixed-income analyst in Morningstar's manager research group.

Joining me today at the Morningstar Investment Conference is Scott Page, portfolio manager for Eaton Vance Floating-Rate funds. Scott, thanks for joining me today.

Scott Page: Thanks for having me.

Desai: We've seen a lot in the news lately about flows into floating-rate funds. There was a streak of about 96 weeks where a lot of money went into these funds, but lately we've seen money coming back out. Can you talk a little bit about what's been going on, and what's been driving the outflows?

Page: Well, the inflows, I think were people's attempt to sort of seal themselves from bond risk because I think the mentality for quite a while was that the yield curve might be lifting, and certainly [there were] tons of warnings about what happens to bonds in a rising-rate environment. So people were looking for alternatives; the list is not long. I think that floating-rate bank loans are one of the probably most responsible ways to deal with that type of risk and still earn income, but not be exposed to declining bond prices in a rising-rate environment.

So that stopped, I'd say, like six weeks or so ago; we started seeing some flows out. It's a little bit of a mystery to me. One is I think bond risk was being looked at slightly differently. I'm a little puzzled by that because rates are still just extremely low.

I think there was a plethora of articles about rising credit risk in certain issues in the high-yield and bank-loan market. So that was sort of a warning that you better make sure that your bank-loan fund is investing responsibly.

Desai: We've been hearing a lot at the Morningstar Investment Conference about a bull and bear case for corporate credit, whether it's high-yield bonds or bank loans. I think the bulls would say that corporate fundamentals are strong; the bears would say that valuations are kind of stretched right now. Where do you see the credit cycle right now?

Page: In terms of sort of debt/EBITDA ratios and the traditional measures that we use to monitor risk, our portfolio looks the same as it always has. I think people are getting concerned about the absolute level of returns, which is again a function of how low the yield curve is, and that's caused people to think, "Shall I really be buying a non-investment-grade bond with X as the expected return?" So, it's really easy to see it either way.

In terms of the bank-loan asset class, Steve Miller did a really good piece and went through the sort of notion seeking, "Is this trade overdone? Have bank loans become a bubble?" And he really picks it apart factually piece by piece, and there is just not a case for it. The spreads that we're seeing with the Libor floors are above median versus the history of the asset class without Libor floors which is just a little bit below median levels. Median is not the stuff of bubbles. Plus you have to keep in mind that bank loans do not trade much past par value [of 100], they don't go to 110 or 115.

So yes, we've seen a lot of money come in. I think that created the environment that maybe the trade was overdone, but the facts don't really support that really having a negative consequence.

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