For CLOs, a Bumpy Path Away from Libor

Collateralized loan obligations (CLOs) pool highly complex and bespoke syndicated loans into securities sold to investors with varying priorities. In the transition away from Libor, the predominant reference rate for floating-rate transactions, that complexity will be multiplied several times over, probably even past mid-2023 when U.S. dollar Libor is slated to end for good.

ICE Benchmark Administration (IBA) finalized March 5 the cessation after this year of two lesser-used USD Libor terms. More importantly, it extended support for the terms commonly referenced by syndicated loans acquired by CLOs until June 30, 2023, providing more time for those legacy transactions to expire or their contractual language to be reworked to switch to a replacement rate.

However, U.S. regulators still want new transactions to be priced over a replacement rate by year-end, and they, along with the biggest banks, have implicitly supported - although not required - moving to the Secured Overnight Financing Rate (SOFR). CLO market participants must consequently prepare to analyze and process several methods to calculate SOFR, as well as Libor-replacement alternatives that may come to fruition, and Libor on lingering existing loans.

“CLOs have all these different types of investors - AAA, mezzanine and equity - and everyone may have different opinions on the benchmark they want,” said Thomas Majewski, managing partner of Eagle Point Credit Co., which invests in CLOs. “The loans have documents that in some cases go back 20 years for long-term issues, when there was no concept of changing the reference rate, and each loan may have 150 holders that all have to agree.”

Meredith Coffey, executive vice president of research and public policy, Loan Syndications & Trading Association (LSTA), said the trade group and CLO managers are increasingly focused on the issue given the “very substantial scenario analysis” involved. In fact, the CLO market may soon have to consider the first syndicated loans priced over SOFR, given that time is running out and the Federal Reserve has turned up the pressure to switch.

In view of IBA and U.K. Financial Conduct Authority statements and “the spread adjustments under the International Swaps and Derivatives Association's IBOR Fallbacks Protocol,” Fed vice chair for supervision Randal Quarles said on March 22, “there is no scenario in which a panel-based USD Libor will continue past June 2023, and nobody should expect it to.”

The IBA's cessation announcement may also spark more SOFR loans, since it finalizes the spread adjustment between the two rates that is critical for transitioning legacy Libor transactions. The Fed-sponsored Alternative Reference Rates Committee (ARRC) has recommended halting USD Libor for syndicated loans by June 30.

A committee progress report on March 22 “underscores the tremendous progress made in transitioning away from U.S. dollar Libor over the past year,” said Tom Wipf, ARRC chairman and vice chairman of institutional securities, Morgan Stanley. “However, it also identifies products, such as business loans, where the use of Libor has not diminished. The ARRC commends all efforts that contributed to progress to date, but time is short. With essentially nine months left to end-2021, it is critical that market participants are actively taking steps to support the transition using the tools available now.”

“Transition Trajectory” for Loans

When alternatives take hold for syndicated loans, CLOs will likely end up holding loan assets referencing different benchmarks, some still in the works. Their liabilities, too, may reference benchmarks calculated in different ways, most requiring more complicated calculations and management than straightforward, USD Libor terms. Investors, meanwhile, will have to track different and changing accrual streams, as CLOs buy and sell assets, that may introduce market risk.

“One of the fundamental issues for the CLO market that is not under its control is what's going to happen in the loan market,” said Gareth Old, a Clifford Chance partner specializing in derivatives and structured finance. “The loans are themselves going to have their own transition trajectory.”

For several asset classes, the ARRC has recommended “waterfalls” for rates to fall back to when USD Libor ceases. At the top of each is a forward-looking term SOFR, which resembles the Libor structure that corporate borrowers favor, since it enables them to forecast their cash positions more accurately. Such a version of SOFR would facilitate the transition operationally, but it does not yet exist, and the derivative-market liquidity required to generate such a rate remains insufficient.

Averaging Methods

The second waterfall rung is a simple average of daily SOFR for syndicated loans and a compounded average for CLOs, both in arrears. The arrears method averages the overnight rate until an agreed upon number of days before the end of the term when the final rate becomes known, a few days before the payment is due.

LSTA's Coffey said the basis between the simple and compounded rates is minuscule and not a major concern, but loans may be priced over other rates, in which case “the basis between assets and liabilities may be substantially larger and uncorrelated.”

For example, SOFR can also be calculated in advance, informing borrowers of their future payments at the start of the term, similar to Libor. However, it is calculated taking a simple or compounded average of daily SOFR over the previous period in question, raising concerns about how accurately it reflects the current economic environment.

In addition, to address regional banks' concerns about a secured SOFR rate not reflecting credit risk, the IBA, Bloomberg and IHS Markit are each working on credit-spread solutions, potentially to layer on top of SOFR rates. And some borrowers may choose well-understood if imperfect rates, such as Fed funds or prime, until the market coalesces around one or more replacement rates.

Active Management

An additional consideration, Coffey said, is the extended transition period for legacy transactions, until mid-2023. CLOs are actively managed, buying and selling assets throughout their lives, so the basis from assets using different rates, potentially including legacy Libor deals and a variety of replacement rates, will change over time.

Currently, all CLO assets and liabilities are priced over Libor. The ARRC recommends using SOFR for new CLO liabilities pricing by September 30. Even if that happens, many existing CLO liabilities will remain priced over Libor until mid-2023.

A growing number of those CLOs' assets, however, will be priced over one of the SOFR variations or another rate, resulting in an ever-changing basis difference, as CLOs receive SOFR on more assets and pay out Libor on their liabilities.

Coffey said many CLOs contain a “flip provision” in hardwired fallback language that switches liabilities to SOFR once 50% of assets are priced over the new reference rate. Subsequently, the CLO will be paying out in SOFR and receiving interest payments in a mix of SOFR and Libor rates, with the latter decreasing as those loans mature or are sold.

“So you'll have to manage the basis both ways,” Coffey added.

Continuing Basis Risk

The basis issue doesn't necessarily end after mid-2023. If the market coalesces around a forward-looking term SOFR (see ARRC update of March 23) before then, and CLOs follow the ARRC's waterfall, then liabilities will flip to that term rate, while assets will continue with whichever version of SOFR they were priced over.

“So now you have a mixed portfolio of daily and term SOFR loans, and you're paying out term SOFR,” Coffey said, adding that the assets theoretically could also have been priced over the credit-sensitive rates now in the works.

The LSTA official noted that interest-rate floors are often included in syndicated loans when rates are low, like today, and may offer a solution.

“Hypothetically, if all your loans and liabilities have an interest-rate floor of 1%, then you don't have a basis problem because you're receiving 1% as the reference rate on your assets, and you're paying 1% as the reference rate on your liabilities,” she said, adding that loans must consistently include such floors going forward, even as rates rise. “That's a key solution to basis risk.”

Diverging Rate Movements

A potential risk resulting from mixing credit-sensitive rates and a secured rate such as SOFR is that they may move in opposite directions in times of financial stress.

“If we have another financial crisis or other stress event then, yes, the basis risk could be really high,” said Ian Walker, head of U.S. middle market research at Covenant Review, a Fitch Solutions service that provides credit-agreement analysis. “But in the current environment, it's less problematic because the spread adjustment, assuming the pricing on new SOFR deals is done correctly, will reflect an equalization of the economics.”

Coffey pointed out that Libor and SOFR would have diverged during the 2008 crisis. But when rates went to zero last March, both benchmarks fell, although Libor not as much as SOFR, resulting in some basis-difference increase.

Automation Can Help

Going forward, at least as big a challenge as the math to track CLO performance is incorporating it into systems to analyze and process the transactions.

“Reconciliation jumps out as an area where we're going to see some hiccups,” said Robert Marinaro, head of product, credit, at Allvue Systems, which services CLO managers and institutional investors. He said challenges will include making sure that deal participants are calculating daily interest accruals the same way, and that correct terms and conditions from the credit agreement have been incorporated.

Marinaro added that the mix of rates, along with the credit-spread adjustments bridging them, makes “the risk profile and the understanding of your return more difficult and complex, unless you're automating those calculations.”

Given that loans should start pricing over Libor-replacement rates soon, some CLO market participants may end up relying on spreadsheets to process transactions. Coffey, who has participated in ARRC committees and worked with major banks and institutional lenders originating syndicated loans, said there will almost certainly be “friction” in the transition, and there could very well be a period of disruption.

She said it is too soon to know whether that will impact the availability of corporate credit; such other factors as fund flows and CLO issuance also play a role, and corporate loan activity is hard to predict.

“It's difficult to draw broad conclusions,” Coffey said, adding, “Who would have thought investor loan demand would be so strong in the second half of 2020?”