© 2024 Arizent. All rights reserved.

Volatility hinders and challenges CLOs' transition away from Libor

The vast majority of commercial loans must still be transitioned away from Libor before the June 30, 2023 deadline, leaving collateralized loan obligation (CLO) managers facing a crush of administrative challenges and a decision that could provoke the ire of some investors.

Rising rates and financial market volatility in 2022 have significantly reduced corporate borrowers' incentives to refinance or reset their loans early, the most effective way to transition existing debt priced over Libor to a replacement benchmark. As of October 31, only 14.9% of the floating-rate CLO debt market and 15.3% of loans in CLO portfolios were priced over three-month term secured overnight financing rate (SOFR), according to J.P. Morgan.

That means the vast majority of CLO debt must transition away from Libor over the next eight months, presenting potential challenges for CLOs in terms of their assets as well as liabilities.

On the asset side, ongoing financial market volatility has halved the refinancing rate of the leveraged corporate loans that CLOs invest in, according to Meredith Coffey, executive vice president of research and co-head of public policy at the Loan Syndication and Trading Association (LSTA).

The drop has resulted primarily from those loans trading well below par for most of this year, requiring issuers that want to refinance to pay up to equalize primary and secondary yields. Since volatility shows few signs of abating, borrowers that have streamlined "amendment fallback" language likely will amend the contractual language of their loans in order to transition to SOFR or another replacement benchmark. In most cases those amendments are relatively straightforward and require a lower consent threshold than typical refinancing deals. 

That said, according to Coffey, there's significant risk in waiting: If an amendment doesn't pass, a borrower may have to pay a much higher prime-based rate for a time after LIBOR ceases. Consequently, borrowers may want to consider pursuing the process sooner rather than later, Coffey said, to avoid overloading the resources required to make the transition before the June deadline. 

"There was a pretty big [resource] crunch in the U.K. when market participants there approached the transition deadline [at the end of 2021)," Coffey said. "And that's a much smaller market."

Pratik Gupta, head of RMBS/CLO research at Bank of America Merrill Lynch, noted that should Libor become unavailable most CLO loans are already written to fall back to the prime rate.

"It clearly will not be conducive for most borrowers to use the prime rate, so they'll be incented to switch," Gupta said, adding, "They will need to start pursuing amendments to make that switch.

CLO managers, meanwhile, will have to monitor their CLOs' legacy Libor loans, adjusting portfolios when loans make the transition, and flipping a CLO's liabilities to the new benchmark when the percentage of its loans priced over the replacement rate exceeds 50%.

"You're starting to see some borrowers reach out to CLO managers and other investors to amend their transactions," Gupta said. "In many cases, they did not really receive any significant objections and they could go ahead with an amendment to change to a SOFR reference rate."

That is predominantly an administrative burden for CLO managers. However, some deals originated in 2017 and 2018 could potentially be amended at the discretion of managers, so investors should contact them proactively to understand their transition timelines and impact, Gupta said.

On the liability side, some managers may also face a difficult decision that could favor one set of investors over another. Refinancing is the preferred method to transition away from Libor, because it is more efficient and reduces fees. CLO equity and debt investors alike will clearly understand their returns under the new benchmark.

CLOs that include "hardwired" contractual language recommended in mid-2021 by Alternative Reference Rate Committee (ARRC)—the industry-sponsored organization that developed SOFR—will automatically transition away from Libor June 30 or earlier at the CLO managers discretion. Neither approach requires lender consent, and the transactions will transition to the risk-free SOFR benchmark plus a pre-determined credit spread adjustment (CSA)—26.2 basis points for three-month SOFR and 11.5 basis points for one-month SOFR.

Older legacy deals, typically originated before 2019, often have no fallback language at all or fallback language referencing another version of Libor. Those deals should automatically transition away from Libor to a replacement rate selected by the Federal Reserve, according to the rule it is anticipated to issue by year-end. That rule will interpret the Adjustable Interest Rate (Libor) Act signed into law by President Joe Biden last March.

More complicated will be CLOs originated in between those two periods that do not specify SOFR or another replacement rate to fall back to nor a spread adjustment but rather give managers discretion to make those choices. Those deals, if not refinanced or amended, should automatically flip to the higher prime rate.

That should incentivize CLO managers to refinance their liabilities into SOFR or another replacement benchmark, or amend their currently Libor-based CLOs to incorporate fallback language away from Libor. However, volatility in today's market could present a conundrum for some.

Paul Forrester, a partner at Mayer Brown, noted that secondary-market CLO spreads have moved toward the ARRC's recommended spread adjustment, as the transition deadline approaches, while the spreads in the primary-market for new deals remains lower. That presents a conundrum for managers whose CLOs' fallback language enables them to select a Libor replacement rate and the accompanying CSA. If those spread dynamics continue, CLO equity investors will want the manager to choose the lower spread being offered in the primary market, while investors in the debt tranches will prefer the secondary-market's higher spread.

"It will be very hard to make them both happy," Forrester said, adding that managers cannot realistically ignore the issue, since that would most likely result in the Fed's Libor Act rule requiring the CLO to transition using the ARRC's recommended spread adjustments. "And that would just upset the equity investors."

Forrester said the widening spread between SOFR and Libor in the secondary market may prompt further consideration of Libor replacements such as Ameribor and the Bloomberg Short-Term Bank Yield Index (BSBY). They are designed to reflect credit risk, although they arguably also maintain some of Libor's shortfalls.

"The replacement rates really should be tracking closer to Libor and reflect the actual economics of financial products such as leveraged loans," Forrester said.

For reprint and licensing requests for this article, click here.
ABS Securitization
MORE FROM ASSET SECURITIZATION REPORT