Zero sum game: Falling Libor raises concerns on floors

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Tumbling interest rates in March threw a wrench into the collateralized loan obligation market that could eventually lead to dust-ups between different stakeholders, market watchers say.

At the heart of the issue is the plunging London interbank offered rate. Buyers of CLOs, which are tied to the gauge, are increasingly factoring the prospect of negative fixings into their due diligence as the Federal Reserve slashes its benchmark to near zero and the three-month Libor briefly sank below 1% in early March. While the likelihood of it going negative remains small (and the rate rebounded to over to above 1.21% later in the month), it reminded managers of a potential major headache for the $670 billion market that buys more than half of all leveraged loans.

That’s because roughly one in five CLO tranches lacks any sort of Libor floor - thresholds that guarantee minimum payouts to debt investors should the reference rate plummet. If Libor were to eventually fall below the spread on these structures, the negative all-in coupon could mean CLO debt holders would in fact owe money back to the issuer. That may benefit buyers of the equity portions of the capital stack, but industry veterans say CLOs are simply not legally or operationally equipped to handle a reversal in cashflow.

“If Libor falls to a level that produces a negative all-in coupon, it is not clear what would happen,” said Dave Preston, a CLO analyst at Wells Fargo. “It does not appear that CLOs have a mechanism for debt investors to pay interest to the CLO. And third-party equity investors are less likely to be forgiving when they are owed payments.”

Libor prints this low are nothing new to the CLO market. The reference rate plunged below 1% in the aftermath of the financial crisis, and didn’t exceed the level again until 2017. But the sheer speed of March’s decline combined with the fact the benchmark was already at depressed levels beforehand have some in the market saying investors shouldn’t rule anything out.

The specter of negative U.S. government-bond yields as monetary policymakers move to cushion the economy against the effects of the coronavirus pandemic also has some wary.

Sub-zero coupons are far from the primary concern for a market that has helped fuel a boom in risky lending and increasingly caught the attention of global regulators. Still, the lack of explicit deal documentation on the matter adds another possible layer of risk, said Nick Robinson, a partner at law firm Allen & Overy. CLO debt holders would be extremely reluctant to make payments to issuers, setting the stage for potential litigation.

“Good luck getting them to do that absent some court order making them do so.”

Bloomberg News