The migration away from the Libor floating-rate benchmark may present challenges to the collateralized loan obligation (CLO) market but is unlikely to impede what market participants foresee as another record year of activity.
Even if production is somewhat less than 2021, managers expect continuing strength in the economy and bulging private-equity coffers to finance abundant mergers and acquisitions this year. BofA Global Research projects $155 billion in new CLO issuance fueled by private equity debt, and it anticipates another $120 billion in refinancings and resets, for a total of $275 billion in production.
That’s lower than 2021’s $155 billion and $220 billion, respectively, but it would make the second highest year for CLO volume, an indication of the market maturing. Daniel Wohlberg, a director at Eagle Point Credit Management LLC, noted that the CLO market has performed well through two major market dislocations, the Great Financial Crisis and the current pandemic, and that a wide swathe of investors now see CLOs as “a mainstream asset class.”
That broader investor base as well as rising inflation and interest rates are likely to result in significant demand for CLO bonds, which in their 30-year history have experienced few defaults and pay an attractive premium compared to comparatively rated fixed-income. And the demand could impact the biggest challenge the CLO market faces this year, which is the migration away from Libor.
All floating-rate instruments, including debt and derivatives, must now be priced over an alternative to Libor, and the secured overnight financing rate (SOFR) appears to be the choice of the broadly syndicated loan and CLO markets. The market has begun to percolate with activity, so the first fruits of 2022 should arrive soon.
John Hwang, portfolio manager at Western Asset Management, with upwards of $500 billion under management, said January 12 that in the previous few days upwards of 10 new-issue deals, a handful of refinancings. Managers are also actively marketing a number of resets. In addition, he said, dealers are now more open to informing investors about their forward pipelines.
“For any of the major dealers, it’s between five to 10 deals that they’re targeting to price through January and into mid-February,” Hwang said. “The pipeline looks very elevated and really not too dissimilar from what we’ve seen over the last three to six months.”
Talking alternative benchmarks
Those CLOs must all be priced over a Libor alternative – the several methodologies to calculate SOFR have emerged among the likeliest candidates. Regulators view SOFR as difficult to manipulate because it is a daily rate generated from transactions in the gigantic overnight repurchase-agreement (repo) market. Borrowers, however, favor debt that carries Libor’s term structure, so they know what their interest payments will be at the end of the term and can plan ahead.
The Alternative Reference Rate Committee (ARRC), which has supported the development of SOFR, approved a term structure for SOFR last summer. However, the lack of liquidity in the derivative market to permit hedging debt priced over three-month SOFR—a common term length for corporate debt—or another term SOFR has required the floating-rate market to rely on one of four methodologies to generate terms from the daily rate.
Unlike Libor that incorporates bank credit risk, SOFR is a risk-free benchmark, which usually rests at a lower level than Libor. All legacy loans must flip to an alternative rate by June 2023. The shift could happen earlier should regulators determine Libor is no longer suitable. The ARRC recommended a “hardwired” credit spread adjustment (CSA) of 26 basis points (bps) to compensate lenders when moving to three-month SOFR—the adjustment varies by loan tenor.
That CSA has been incorporated into the fallback language of recent loans priced over Libor or amended into legacy-loan contracts. However, the market today is pricing the CSA much lower than 26 bps.
“The CLO market seems to be gravitating toward” a pricing of 130 -140 bps, depending on the liquidity and size of the manager running the transaction, Hwang said. Assuming a respective spread over Libor of 115-125 bps, that implies a CSA of 15 bps.
Should that discrepancy persist and loans flip to SOFR using the higher hardwired CSA, borrowers will be displeased at the effective interest-rate increase, noted Paul Forrester, a partner at Mayer Brown.
“There’s a real risk we’ll have substantial amendment activity in the loan market to fix the spread problem that we’ve built in,” Forrester said. He added that such amendments would not be contentious, because the loan market has tended to adopt variations of the ARRC’s fallback language, but they would still be annoying.
A challenge to CLO legacies
A significant volume of loans refinancing from Libor to SOFR coupled with M&A-fueled new transactions priced over SOFR could have a significant impact on legacy CLO bonds well before the 2023 deadline to transition all transactions away from Libor. Many deals hold contractual language stipulating that they must convert from Libor to SOFR when SOFR-priced loans exceed 50% of their loan pools.
That could present challenges for CLOs’ arbitrage if their assets have refinanced to SOFR at the lower CSA level, but their liabilities, following the ARRC’s hardwire guidance, must flip to SOFR using the CSA of 26 bps.
“It wouldn’t be shocking to see that scenario,” Hwang said, when loan spreads compress and CLO liabilities take additional time to adjust.
“In that scenario you could see a lull in CLO issuance, at least temporarily, until the arbitrage economics adjusts to a level where issuance makes sense again,” Hwang said.
Taking into consideration that possibility, Pretium structured its most recent CLO in Q4 2021 as a one-year call rather than the typical two years.
“If the market-based implied CSA ends up being meaningfully tighter than 26 bps,” that CLO could be called after one year, said Jerry Ouderkirk, senior managing director at Pretium who oversees both CLO management and investments.
“We’re mostly interested this year in seeing how quickly the current Libor-based universe of loans dwindles,” Ouderkirk said.
Accommodating early conversions
Early CLO conversions to SOFR would present an operational challenge both to CLO managers and investors monitoring cash flows. CLO managers must opt for one of the four methodologies to calculate daily SOFR and perhaps a SOFR term rate will have emerged, while the assets will likely be a mix of loans priced over Libor and a hodge-podge of SOFR, creating basis differences and risk.
“It’s an extra administrative burden but not insurmountable,” said Thomas Shandell, CEO and CIO of Marble Point, a CLO manager with $7 billion in assets under management.
Rising interest rates could present a solution to the CSA issue, since in that scenario Libor should increase more than SOFR, thus pushing the differential closer to 26 bps. Whether CLOs flip to SOFR before the 2023 deadline or not, however, market participants see investor enthusiasm for the bonds remaining strong.
An indication of that is the successful launch of Janus Henderson AAA CLO ETF, which has more than tripled in terms of asset under management, to $400 million, since last July. The asset manager announced January 12 launching the Janus Henderson B-BBB CLO ETF, which securitizes lower-rated portions of the CLO and pays investors approximately Libor plus 330 basis points out of the gate and in the high 400s on a go-forward basis, according to John Kerschner, portfolio manager at Janus.
That’s a healthy premium to comparably rated fixed-income, even without the benefit of being floating rate in a rising-rate environment, Kerschner said, “You really have to go down to single-B in high-yield land to get that type of yield.”
