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

Sumit Desai, CFA

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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Desai: You mentioned some of the risk of the money coming out. Talk about the liquidity in this market because that's also a concern that many investors have.

Page: Right. Liquidity risk is the monster risk in bank loans. I can pound the table and put up 10 or 15 different slides, and I think build a very convincing case of the credit risk, at least in the types of funds that we manage--our philosophy is manageable.

What is less predictable is how many people went out of the asset class at any given time, so that could be retail outflows. Of a lot of this money that came in, a certain percentage of it reverses. There are more sellers than buyers of bank loans in a given period of time, and bank-loan prices go down, without changing at all the actual fundamental risk we're taking, which is corporate credit risk--can these companies repay their debts as they come due? So that historically has exceeded the sort of underlying fundamental risk. I just think it's so important for investors to be aware of that because they may buy bank loans at par. They're going to achieve the objective they're trying to achieve, and yet they may see bank loans trading down 97, 95, or maybe even lower [versus a par value of 100].

They need to have confidence that what they have is a par piece of paper. We make loans at par. We get them back at par; 97% of the companies historically in our portfolio repay us at par, the other 3%, in a reorganization we get 70% of the money. So if you see a well-diversified, well-managed bank-loan fund trading significantly below par, keep in mind that you have a good chance of getting that back.

Desai: You mentioned well-managed funds. I think that your strategy within the space is a little bit different than some of the other funds out there. Talk a little bit about how you specifically approach the bank-loan market.

Page: We are stability-seeking managers. Our strong belief is that conservative is not a word I like, but to have an aggressive stance in an asset class, to sort of wander out on to the frontier--and there is a frontier in every asset class--for bank loans, they are smaller, highly leveraged, less liquid deals that yield more.

However, to be out on a frontier, our belief is you have to have more upside, and almost by definition in bank loans there is no upside. So we lack the incentive to be out there. So we back away, and we do what we regard is the stable core of the asset class.

Then we use our process, our experience, and our large team to sort of optimize that through time. That has the result of us rarely being the highest-yielding fund, but we think that the dividend, or the payoff, for that is by having more stable performance when the inevitable credit storm occurs. Then the added bonus is that behaviorally people will be less afraid, we hope, and therefore less likely to take the money out of the fund at the wrong time.

Desai: Scott, thank you for joining me today.

Page: Thanks for having me.