Starting yields historically have been reliable guides to future returns. By that measure, floating-rate loans should draw attention, both in comparison with other fixed-income sectors and relative to their own history. For example, the chart below shows how the yield on loans has recently moved higher than high-yield bonds, reversing their typical relationship. As of August 31, 2019, the yield on loans was 6.7%, based on the S&P/LSTA Leveraged Loan Index, compared with the 5.9% yield on the ICE/BofAML US High Yield Index. By way of comparison, the benchmark Bloomberg Barclays U.S. Aggregate Index is yielding 2.1%.
Loan yields are also higher than those of emerging-markets debt - again reversing the typical relationship. Keep in mind that with loans, there aren't the currency or political risks of emerging markets debt, and relative to high-yield, loans are senior in the capital structure and secured. The yield on loans today is also historically high, relative to their long-term average total return - about 6.7% to 4.9%, or a 180-bps advantage.
What's behind the rise in loan yields? A key factor is the inverted yield curve. Loans are generally priced off of 1-month Libor, which yielded 2.09% on August 31, 2019, while high-yield bonds are priced off comparable-maturity U.S. Treasury bonds. As of August 31, 2019, both the 10-year U.S. Treasury (yielding 1.50%) and the 5-year U.S. Treasury (yielding 1.39%) had yields lower than Libor. So in the unusual environment of an inverted yield curve, loans were being priced off of a higher-yielding benchmark than high-yield bonds - that's a big factor in the atypical loan/bond spread.
Negative retail sentiment is also keeping yields higher than normal. Loans have experienced large net outflows from the retail sector - more than $20 billion this year, following $18 billion in December 2018, which puts upward pressure on loan yields. The net outflows have helped push the market price of the S&P/LSTA Leveraged Loan Index to 96, while other fixed-income sectors are trading above par, or just under.
Most of this negative sentiment is predicated on the common belief that floating-rate loans must underperform in a falling-rate environment - a misconception we'll address in a subsequent blog. Retail loan investors represent approximately 10% of the market, but at times (like these) can have an inordinate impact on loan prices.
Bottom line: Investors who equate falling rates and Fed accommodative policy with subpar loan performance should take a closer look at today's yields. It's also instructive to review loans' history in falling-rate environments - something we'll do in the next blog.
Andrew Sveen, co-director of Bank Loans, Eaton Vance