Equity-Like Return Potential in the Loan Market

Sponsored by Eaton Vance

Editor’s note:

Before Bob retired from VettaFi, he sat down for this interview with Morgan Stanley’s Jake Lemle. We were unable to publish the interview before his departure, but we’re excited to have the opportunity to share it with you now.

– Lara Crigger, editor-in-chief, VettaFi

Guessing the direction of interest rates is no easier than any other tactical or market timing decision. The yield on the benchmark 10-year Treasury note is just under 3.9%. That is about 100 basis points less than it was a few months ago. Fed policy is uncertain, inflation has not been fully controlled, and fiscal deficits loom as a long-term risk for yields to go higher.

Those factors argue in favor of an allocation to floating-rate notes.

Jake Lemle, CFA, is managing director, head of loan trading & capital markets, and a portfolio manager at Morgan Stanley Investment Management.

Jake is a managing director of Morgan Stanley Investment Management Fixed Income, head of loan trading and capital markets and portfolio manager on the floating-rate loan team. He is responsible for trading high-yield loans and bonds for the senior debt group as well as public funds, separate accounts, commingled institutional accounts and structured products. He also has responsibilities for buy and sell decisions, portfolio construction and risk management. He began his career in the investment management industry with Eaton Vance in 2007. Morgan Stanley acquired Eaton Vance in March 2021. Jake earned a B.S. from Georgetown University. He is on the board of directors of Artists for Humanity in South Boston and a member of the Acquisitions Circle of the Institute of Contemporary Art, Boston. He is a CFA charterholder.

I spoke with Jake on February 2. This is an abridged version of a podcast I did with Jake, which you can listen to here.

Tell me a little bit about your career path. Who is Eaton Vance? What is its relationship to Morgan Stanley and what do you do there?

Eaton Vance and Morgan Stanley have a new marriage. We were acquired by Morgan Stanley in 2021, and Eaton Vance is probably a familiar name to many of your readers. But for those who don't know us, we're a global asset manager headquartered in Boston. One of our key areas of expertise is in credit. We were a pioneer in managing high-yield loans and bonds with our flagship funds, sporting inception dates back in the late 1980s. Today, Eaton Vance has one of the largest and most respected leveraged-credit platforms. I am privileged to have spent my entire 17-year career here with the new partnership and ownership under Morgan Stanley. The opportunity set just got a whole lot bigger. Our franchise is a shining example of consistency and investment process over a very long time.

I'm a senior portfolio manager on a range of different strategies, and I run our trading and capital markets effort for the floating-rate-loan team. I grew up trading, which forged my skills in managing risk and asset positioning and in portfolio construction. Eaton Vance specializes in active fundamental credit management, and I've spent my career helping build and grow this capability as the market has evolved and matured into what's now a $1.5 trillion asset class.

Tell me about the opportunity set in the senior-loan asset classes. Is this an attractive environment to be allocating to for senior loans?

I believe it is. It's not quite as good as it was a year ago, but the world is still massively underweight credit, and the yields are impossible to ignore. The Morningstar LSTA US Leveraged Loan Index put up 13+% return last year with a vast majority of that coming through current income. We were talking about equity-like returns delivered contractually, which are secured by the assets and cash flows of large, mainly U.S. companies that have enduring enterprise value and durable cash flows.

Long story short, it was a good 15-year run, but now we're in what I consider to be the early innings of a golden age for investors to make equity-like returns using credit, and on a risk adjusted basis it's even better.

You mentioned that the asset class returned 13% last year in 2023. What was the performance of the year before that? To what do you attribute those results during a fairly difficult period for bonds?

It's a good opportunity to step back in time to where we were a year ago. Coming into last year, 2023, stocks were in a brutal bear market. There was nowhere to hide. Investor psyche was demoralized and fragile, and strategists across the street were calling for a hard landing or at least some type of recession. I even remember one bank strategist had a -20% return expectation for the loan market. They missed that one by 30%-plus. What did they get wrong? There wasn't widespread distress or even moderate distress among issuers. There wasn't pain across the economy the way many were predicting. Some sectors certainly had their struggles, and we've seen our typical idiosyncratic credit problems that pop up along the way.

But in the end, the loan market has been a major beneficiary of the Fed's rate-hike regime and the inverted yield curve. We've got 5.5% to 6% base rates plus a spread and all in coupons in the 9% to 11% current-pay range. The economy and corporate earnings have by and large surpassed very negative expectations. Our portfolios are built around durable cash flows from large companies that were able to manage through the supply-chain shock and cost inflation. They were able to pass through prices, delay capital expenditures, manage their staffing levels in a tough labor market, and pull all the right levers as big, sophisticated companies are typically able to do, given their experience. It's been a picture of resilience and even a pleasant surprise in some spots.

You mentioned that you've done well in an environment of rate hikes and an inverted yield curve, The Fed seems to be poised to lower rates, although there's a lot of debate about how soon and how precipitous that decline will be. How are floating rates positioned given that environment?

Jay Powell threw everyone a curveball in late January and said that he's not planning a hike in March. But it's a fair question, and we should admit that forecasting where rates are going is gambling. The forward curve and the Fed dot plot are wrong pretty much 100% of the time.

When the Fed cuts, and we can say it will at some point, it will shave some of that coupon down. But we're starting with such a high relative yield advantage that when yields come down to 8% or 9% on loans, I'll still be beating the same drum.

When the Fed does start cutting, a lot of our issuers will see their debt-service costs decline and their businesses pick up as economic activity picks up across the board.

But if you told me, " I'd rather us own a long-duration, fixed-rate bond right now. The Fed's going to be cutting rates," I don't think that's at all irrational. Duration was not your friend for essentially two years, until the fourth quarter of last year when rates rallied sharply. But maybe that trade's over. Trying to predict where the 10-year Treasury is going to be is a fool's errand. I am not in the room with the Federal Reserve Board, but I would guess that they're keen to get the curve back to an upward sloping, normalized term premium. What that means for where rates are going to be is anyone's guess.

You mentioned that you've spent your entire 17-year career at Eaton Vance, now at Morgan Stanley. Eaton Vance has been investing in the loan asset class for a long time, and you've developed a particular edge. You mentioned at the outset that your paradigm is active, fundamental credit research. Tell me about what gives you and your team an edge in this asset class?

We've got a huge, deeply experienced research team doing fundamental credit analysis. It's an intensive credit culture that's focused exclusively on the loan asset class. A lot of our competitors have a centralized research function that different sectors tap into.

I believe our structure has a big competitive advantage over them. Everyone knows what team they're playing for. We've all been playing together for a long time, and the process works. Credit investing is about knowing the names, avoiding trouble, living in the future, seeing around the corner, and anticipating problems, be it at the issuer level or a broader sector call. For example, our analysts have seen the way the auto-cycle has ebbed and flowed over a 25-year career.

We've got all the capabilities to broaden the opportunity set in a lot of our strategies using allocations to adjacent products and asset classes, like high-yield bonds and CLOs. Being active pays off in our market. It does not work when you're buying an index fund in leverage credit; you're buying the issuers that have the most debt, which is not a great strategy.

Your team has a new ETF coming out. The symbol is EVLN. It taps into the same team and investment platform that underpins your longstanding mutual funds. Tell me more about EVLN and how it’s constructed.

We've had clients asking for an ETF for years. We're finally giving our clients what they want. The ETF uses the same team, investment style, and discipline that investors know us for in a new wrapper. The ticker is EVLN, which is short for “EV loan.” The biggest loan ETF is a passive index fund, which underperforms the index throughout time, and the expense ratio on that fund is 67 basis points. It is not only expensive, but it does not do any work. We just talked about how passive doesn't work in our market. The key is that we at Eaton Vance are true loan-market experts, and this is an active strategy that's going to highlight our best ideas.

If there's one key takeaway that you'd like to leave with our readers about the diligence and the research they should perform before allocating to the loan asset class that you focus on, what would that be?

The yield is overwhelmingly exciting to me. It's not very long ago when our asset class was yielding 3% to 4% and the risks were quite similar. This is not a scary time to be investing in the loan market, and the relative yield advantage that you get from day one is undeniable.

Bob Huebscher was the founder and editor of Advisor Perspectives.

Important Information

Data as of: February 2, 2024

A basis point is a unit of measure, equal to one hundredth of a percentage point, used in finance to describe the percentage change in the value or rate of a financial instrument.

Risk Considerations: There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this portfolio. Please be aware that this portfolio may be subject to certain additional risks. Loans are generally associated with fixed income securities risk and are traded in a private, unregulated inter-dealer or inter-bank resale market and are generally subject to contractual restrictions that must be satisfied before a loan can be bought or sold. These restrictions may impede the Fund's ability to buy or sell loans (thus affecting their liquidity) and may negatively impact the transaction price. It may take longer than seven days for transactions in loans to settle; therefore the Fund may hold cash, sell investments or temporarily borrow from banks or other lenders to meet short-term liquidity needs. Loans to entities located outside of the U.S. may have substantially different lender protections and covenants as compared to loans to U.S. entities and may involve greater risks. Loans may be structured such that they are not securities under securities law, and in the event of fraud or misrepresentation by a borrower, lenders may not have the protection of the anti-fraud provisions of the federal securities laws. Loans are also subject to risks associated with other types of income investments. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. In addition to fixed income securities risk, asset-backed securities are subject to the risk that various federal and state consumer laws and other legal and economic factors may result in the collateral backing the securities being insufficient to support payment on the securities. Some also entail prepayment risk and extension risk, and may become more volatile in certain interest rate environment. 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