The first broadly syndicated loans (BSLs) priced over the secured overnight funding rate (SOFR) have approached the market, but whether the floodgates open to more loans priced over the Libor-replacement rate remains uncertain. Investors may not even see new collateralized loan obligations (CLO), which purchased 70% of leveraged loans last year, priced over a Libor-replacement rate until well into next year.
Regulators have set a year-end deadline to price all new floating-rate transactions over a Libor-replacement rate, and BSLs priced over SOFR have started to emerge, starting in September with Ford Motor Co.’s massive $15.5 billion refinancing of investment-grade debt.
More pertinent to CLO investors, Wayne Farms launched in September and has successfully syndicated a $750 million leveraged loan with a portion slated for institutional investors that is initially priced over Libor and flips to SOFR next year. This week Walker & Dunlop was expected to price a $600 million, seven-year leveraged loan priced over SOFR. And, according to LevFin Insights, two more SOFR-priced loans launched this week: Draslovka Holding A.S.’s $350 million term loan B acquisition financing, and a $1.35 billion repricing.
The large global banks prevalent in the BSL market are paving the way for more non-Libor deals. They expect to offer borrowers a Libor-replacement rate first, starting in the fourth quarter, according to Meredith Coffey, head of research at the Loan Syndications and Trading Association (LSTA), who has heard from members.
“Borrowers can always say, ‘No, I want to do Libor,’ but the first proffer will be a Libor replacement-rate,” Coffey said, adding that most banks have said they will offer SOFR but they could also provide an alternative replacement rate such as the Bloomberg Short-Term Bank Yield Index (BSBY).
Whether or not non-Libor pricing snowballs as the year-end deadline approaches, there will be plenty of opportunities given the record volume of loans from borrowers taking advantage of low rates. Expect plenty of demand from the CLO market, which is anticipated to reach record volume this year of at least $150 billion in new issuance, and double that when refinancings and resettings are included.
“Investors are starved for yield, and this is one asset class that continues to offer that yield,” said John Kerschner, head of U.S. securitized products at Janus Henderson Investors, adding that floating-rate CLOs allay concerns about interest rates continuing to rise.
Hurdles in switching to Libor-replacement rates remain, however. As the loan and CLO markets work through them, that effort might delay enthusiastic adoption of them.
Kerschner noted that the mostly standard documentation for loans priced over Libor—often stretching more than 300 pages—may prompt investors to stick with what they know as they seek to meet their targets by year-end. In addition, some may hesitate taking first-mover risk when there’s little real benefit apart from making headlines.
“But, obviously, we have this deadline, so I expect to see more and more deals coming out over SOFR,” he said. “And by year-end I would expect pretty much all of them to be over SOFR.”
The complication of basis differences
Another issue that could prompt hesitation to price new loans over SOFR—the Libor replacement that the BSL market has adopted so far—stems from the basis difference between risk-free SOFR and Libor, which incorporates lender credit risk. The difference between today’s SOFR and three-month Libor is an historically tight 11 basis points. That compares to a mean basis difference of 26 basis points between the two rates over the last five years, as calculated by the Alternative Reference Rate Committee (ARRC), a private consortium that has overseen the development of SOFR.
Roughly half of loans are structured with a floor, typically resembling Walker & Dunlop’s 50-basis-point floor, which provides investors with a minimum return. That neutralizes a future basis adjustment of 26 basis points for those loans, since Libor plus the adjustment will not exceed the floor threshold.
However, CLOs may hesitate purchasing loans until they have a better understanding of the dynamics on the liability side, where bond payments are made quarterly and there is no floor. CLO investors likely favor the higher 26 basis point spread differential, but CLO managers increasingly see such a wide difference as punitive.
“The true [difference] will likely be closer to 10 basis points, if not tighter, versus the 26,” said John Hwang, portfolio manager at Western Asset Management, adding there’s precedence from other markets that have already issued SOFR-priced transactions, and a deal now in the market launched its initial price talk with a 10 basis point adjustment to SOFR, in addition to the credit spread.
The wider the spread adjustment, the more it will erode the asset-liability arbitrage that fuels CLOs, potentially slowing the launch of new CLOs. And the uncertainty of how to price loans over SOFR could encourage further use of Libor this year.
“How robust issuance this quarter will really depend on how quickly we get through this price discovery stage,” Hwang said.
Daniel Wohlberg, a director at Eagle Point Credit Management, agreed that the appropriate basis between Libor and SOFR has been an issue in terms of pricing new loans and CLOs pricing over SOFR.
“That’s been a major holdup in our market so far,” Wohlberg said. “Everyone knows that it’s closer to the spot difference today, and 26 basis points is not the right number, but no one is incentivized to be the first mover yet.”
Once the issue is resolved, he added, there might be a cascading effect in light of the record volume of loan issuance available to CLO bonds’ low default rates and attractive yields compared to other investment products.
“Even if there’s some sort of short-term lag in figuring this out, as we hit that bright line at the end of the year or maybe even several weeks before that people will solve the issue, because the volume and demand are there,” Wohlberg said.
A choice of alternatives
J. Paul Forrester, a partner at Mayer Brown, said the BSL market appears resigned to pricing loans over SOFR, rather than a credit-sensitive Libor alternative such as BSBY, at least for now, and his firm is internally training its lawyers to prepare for the pricing shift. He added that he expects mechanical issues, such the appropriate observation period shifts, will take time to work out.
“That optionality, which is still evident in the market, has to be squeezed out. And that’s going to take time because it’s really operational stuff that people have to work their way through,” he said.
Hedging term SOFR might be another difficulty. The ARRC recommended this tactic in early July, intending to provide a deal structure more closely resembling Libor and thus facilitating the transition. The dearth of new deals priced over SOFR, however, means there is insufficient liquidity from underlying transactions on which to price swap hedge.
The recently launched loans pricing over SOFR are taking tentative steps toward term SOFR. Wayne Farms starts with daily simple SOFR, one of four ways to calculate the daily rate, and becomes a term rate when agent Bank of America determines the term SOFR is administratively feasible, according to Ian Walker, head of U.S. middle market research at Covenant Review. Walker & Dunlop starts out with term SOFR and will fall back to daily simple SOFR if term SOFR, which may face similar liquidity challenges to term Libor, stops permanently.
More loans pricing over term SOFR will eventually provide the liquidity necessary to support hedges, but until then CLOs will lack an important tool to mitigate basis risk stemming from the changing mix of SOFR- and Libor-priced loans CLOs will initially hold a as the transition progresses. That suggests CLOs may not be priced over SOFR until well into 2022, when the swaps to hedge that risk become more readily available.
Before then, “You’d be putting a deal out there that has a lot of basis risk that you can’t hedge today,” Forrester said.
