Few asset classes have received as much attention lately as bank loans (also known as senior loans or floating-rate loans). In the past 12 months, $54 billion has flown into the open-end bank-loan category as income-seeking investors look for protection against a potential rise in interest rates. As we've discussed before, senior loans pay interest to investors based on a floating rate that is generally reset quarterly. That rate is based on a reference index or rate (usually Libor) plus a spread, which is generally determined based on the credit risk of the portfolio's underlying assets. So, in a rising-rate environment, floating-rate loans should pay investors more income.
These investments are not without risks, though. Many bank loans were recently issued with Libor floors that rates must exceed before higher coupon payments start kicking in. As a result, rates may need to increase dramatically before investors see any benefits from owning certain loans. Also, floating-rate loans still carry significant credit risk. Corporate fundamentals remain strong and default rates are low, but any signs of weakening economic activity could hurt this category. It's feasible that the fast money that poured into bank-loan funds may just as quickly pull out at the earliest signs of distress. Flows don't have a direct impact on closed-end funds on a net asset value basis, but sharp outflows from open-end funds could still have an impact on CEF performance. In addition, negative investor sentiment could widen discounts across the sector, hurting share price performance.
Among closed-end bank-loan funds, Eaton Vance Floating Rate Income's (EFT) fundamentally sound, repeatable process makes it a standout. Because of this, we recently upgraded the fund's Morningstar Analyst Rating to Silver from Bronze. The fund's restrained approach may not consistently land it in the top tiers of the bank-loan category, or even atop its benchmark, the S&P/LSTA Leveraged Loan Index, but over time it has kept up with its peer group while keeping volatility in check. The fund returned 5.2% for the year ended April 6, 2014, compared with 7.4% for the category average, placing it behind 85% of its peers. A key driver of this underperformance was the fund's general avoidance of CCC loans, which performed significantly better than higher-quality loans in 2013. Over the past five years, though, the fund’s 19.2% annualized return is right in line with the category average.
For investors who are interested in Eaton Vance Floating Rate Income, shares appear reasonably valued: The fund currently trades at a 4.7% discount, which is near its six-month average but much lower than its three-year average premium of 0.67%. Over the past three years, the fund has traded between a premium of 10.4% and a discount of 9.7%.
People
Scott Page, who has managed this fund since its inception in 2004, is a longtime veteran of the bank-loan asset class. He joined Eaton Vance as a bank-loan analyst in 1989. Craig Russ, director of credit analysis, oversees all credit research for the floating-rate group. He joined Page in 2007. Ralph Hinckley joined this fund's team in 2008 and was previously a credit analyst for the firm.
Managers are supported by a 13-person analyst team, which includes eight veteran analysts, each of whom has more than a decade of experience. Other resources supporting the group include a formal two-person team dedicated to handling workouts and an additional trader.
The team earns high marks on several funds it manages, including open-end Eaton Vance Floating Rate (EVBLX) and Eaton Vance Floating-Rate Advantage (EIFAX), which also earn Gold and Silver Analyst Ratings, respectively.
Process
The fund must hold at least 80% of its assets in bank loans but generally holds closer to 90%. The remaining allocation is flexible, but typically, its managers hold high-yield bonds and some asset-backed securities.
This fund's approach is centered on fundamental credit analysis. The process starts with a screen that eliminates issuers that are too small and highly leveraged. The analyst team, which is highly active in the primary market for newly issued transactions, assesses each borrower's competitive position, management strength, and business risk, as well as quantitative measures of its financial strength and stability. Attention then turns to the borrowing transaction itself, with analysis both of the structure of the underlying deal and the strength of its covenant package. Finally, the team reviews each loan's risk/reward trade-off relative to other opportunities in both the primary and secondary markets. The analysts then assign rankings to each loan based on quality and valuation. The managers will typically give higher allocations to loans that receive higher analyst rankings.
The managers mostly eschew CCC rated transactions, arguing that, over time, they've not paid enough to offset their significantly higher default rates. That said, the team will occasionally venture into lower-related loans if the underlying collateral provides a safety cushion. The team also conducts periodic relative-value and risk assessments of large sectors within its portfolio.
The fund generally holds a higher credit-quality portfolio than many of its peers. As of Dec. 31, 2013, its 44.6% weighting in BB rated loans was much larger than its CEF bank-loan peers' (an average of about 32.3%), and its 46% weighting in B rated loans was smaller than its peers' (an average of about 51.7%). The fund's CCC allocation of 2.8% is well below the category average of 6.7%. It also had most of its assets in domestic senior loans (85%) with a small allocation to foreign bank loans (3.5%) and high-yield corporate bonds (6.5%). Overall, the portfolio was highly diversified with 447 issuers.
The fund's top sectors included health care (9.7%), business equipment and services (9.1%), and electronics/electrical (7.7%). The top 10 loans accounted for about 10% of the entire portfolio.
Leverage
The fund's current total leverage ratio of 1.61 (total assets divided by net assets) is among the highest in the CEF bank-loan peer group. Of the $380 million in total leverage used, $300 million came from a revolving credit agreement with a bank, for which the fund is charged an annual fee of Libor plus a spread. The remaining $80 million came from the issuance of variable-rate term preferred shares, which were issued in 2013 to redeem and replace the fund's previously issued auction preferred shares. In total, the fund's leverage cost about 0.66% of total assets in fiscal 2013.
The interest and dividend rates paid for leverage are not fixed. While this currently allows for fairly cheap leverage financing, the cost of leverage also will rise if short-term rates rise in the future.
Distributions and Performance
As of April 7, 2014, the fund paid a distribution rate of 5.8% at share price and 5.5% at NAV. While this distribution is lower than the category average of 6.5%, we like that the fund has usually been able to meet its distribution from income generated by its underlying holdings. That said, the fund did return capital to shareholders in 2008 and 2009, but the total use was small both times. The fund changes its distribution regularly according to income earned.
The fund has underwhelmed in the recent past. Over a longer time frame, its returns are in line with the closed-end bank-loan category average. It returned 5.2% over the past year ended April 6, 2014, compared with 7.4% for the category average, placing it behind 85% of its peers. Over the past five years, the fund grew 19.2% annually, in line with the average. Since its June 2004 inception, the fund has returned an annualized 5.6% compared with 5.4% for the category. The fund's conservative portfolio composition has left it slightly behind the category as lower-quality CCC rated loans have generally performed better than higher-quality loans during the recent bull market and low default rate environment. In 2013, CCC rated loans returned more than 10.4% on average as default rates remained low and dollars flowed into the asset class.
Fees
The fund's adjusted (excluding leverage) fiscal 2013 expense ratio of 1.38% was below the 1.43% average for CEF senior loan peers. Interest and other expenses added an additional 66 basis points.
The fund does not have a declining fee schedule in which fees decline as assets rise. We believe such schedules benefit investors. Advisor fees are 0.75% of average weekly gross assets (including leverage).
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