CLO investors find silver lining in Libor’s demise

Collateralised loan obligations (CLOs) are warming to the idea of using a compounded-in-arrears version of the secured overnight financing rate (SOFR) to pay debtholders, rather than waiting for a forward-looking term equivalent.

The loan market had been expected to hold out for a forward-looking SOFR term rate before moving away from Libor. But after being stung by a widening basis between one- and three-month Libor in early 2018, CLO equity investors are pushing for a more stable, backward-looking rate.

“Market participants are increasingly starting to see the benefits of SOFR compounded in arrears,” says Meredith Coffey, executive vice-president of research and public policy at the Loan Syndications and Trading Association (LSTA). “Over the last year, many of the people in the loan market said they would wait for a forward-looking term rate, but I think that view is changing now.”

CLO debt typically references three-month Libor. However, the underlying levered loans give borrowers the option of paying a rate based on either one- or three-month Libor. When the spread between the two widened out to as much as 46 basis points last April (see chart), borrowers opted to pay the lower one-month rate. That hit CLO equity investors, who take first losses in the structure.

If an equity tranche is levered 10 times, a 46bp drop in interest distribution translates to nearly 3% per annum of lost revenue for investors.

“For equity distributions, it wasn’t pleasant,” says Laila Kollmorgen, a managing director in the leveraged finance group at Pinebridge Investments.

Moving to a backward-looking SOFR term rate, where coupons are calculated by compounding the daily overnight rate in arrears, “certainly makes a lot of sense for dedicated CLO equity investors and I could see that being a move that decreases that basis risk”, she says.

Kollmorgen manages Pinebridge’s investments in CLOs issued by third-party managers.

The LSTA’s Coffey agrees that basis risk would be reduced by using a backward-looking term rate. “If we moved to SOFR compounded in arrears, any basis between the assets and liabilities would be much lower because compounded three-month SOFR is simply an extension of compounding off one-month SOFR, so the curve would be much flatter,” she says.

The loan market was expected to baulk at using a backward-looking term rate where the coupon is known only at the end of the compounding period. Libor, on the other hand, is forward-looking – a borrower knows at the start of the period how much its coupon will be at the end.

However, a forward-looking term rate for SOFR, which is contingent on a robust derivatives market developing, is not expected to be available until the end of 2021 at the earliest.

CLO issuers are not waiting around. Several deals have already adopted fallback language crafted by the Alternative Reference Rate Committee (ARRC), which calls for the use of a compounded SOFR term rate if a forward-looking version is not available when Libor ceases publishing.

“We are seeing some signs that investors are comfortable with compounded SOFR," says Ryan Suda, a partner at law firm Mayer Brown. "The most recent iteration of the Libor fallbacks being included in CLOs are including a version of the ARRC replacement waterfall that does start with term SOFR before going to compounded SOFR. The fact that is being included in documents now before term SOFR exists suggests that investors are willing to accept they may end up with compounded SOFR.”

The ARRC recommended two fallback options: one referred to as the ‘hardwired’ approach and the so-called ‘amendment’ approach. The former provides a greater degree of certainty, with a waterfall of alternative reference rates that will automatically replace Libor when it comes to an end. The first of these is a forward-looking term SOFR, followed by a backward-looking rate and, finally, an alternative rate mutually agreed by the borrower and the loan administrator.

The initial focus was on minimising value transfer and disruption upon transition, but now the market is also starting to focus on minimising basis risk going forward

Ian Walker, Covenant Review

Mayer Brown’s Suda says most CLOs are using the amendment approach, which gives counterparties more flexibility in selecting a replacement rate. One of the more common fallbacks being adopted by CLOs will see the reference rate switch to either a three-month term version of SOFR or the reference rate used by the majority of quarterly pay loans in the portfolio.

While some investors prefer the certainty of the hardwired approach, most are encouraged by the adoption of ARRC-recommended fallbacks. “Very damaging fallback rates like the prime rate are typically no longer options [in CLOs],” says Kashyap Arora, structured credit portfolio manager at DFG Investment Advisers, which manages credit funds and CLOs. “In some older deals, if all else failed and Libor was no longer a viable option, the prime rate, which is significantly higher, would become the new reference rate, creating the risk of a large asset-liability management issue.”   

CLO investors now want borrowers in the leveraged loan market to follow suit. “It would be good to see a corresponding effort in the loan market, which generally leaves the replacement of Libor to a negotiation between agent banks and borrowers,” says Arora.

This is starting to happen.

According to analyst firm Covenant Review, of the 104 syndicated loans that were issued or amended in the third quarter, only 14 adopted the ARRC’s amendment approach, which was published on April 25. Most of the other deals use fallback language that predates the ARRC’s final recommendations, although these still cling fairly closely to the official version.

Ian Walker, an analyst at Covenant Review, says concerns over basis risks have spurred take-up of fallbacks. “The market is starting to make the connection between hedges, cash products, and securitisations of the underlying cash products. The initial focus was on minimising value transfer and disruption upon transition, but now the market is also starting to focus on minimising basis risk going forward,” he says.

Some CLO investors want borrowers to go one step further and give up the option to switch between one- and three-month rates, which would get rid of the basis risk entirely.

“While efforts to standardise Libor replacement language in CLOs are welcome, compounding SOFR in arrears still does not eliminate the risk of an asset-liability mismatch for CLO equity, as most language stipulates that replacement rates must have a three-month tenor,” says DFG's Arora. “Borrowers will likely retain the option to toggle to a one-month rate and we could still see a basis between one- and three-month rates reduce excess spreads.”