CLOs face uncertain transition to post-Libor market
It’s no longer if, but when.
On June 22, the Alternative Reference Rates Committee (ARRC), a group of market participants assembled by the U.S. government, selected a broad Treasuries repo financing rate as an eventual replacement for U.S. dollar Libor.
It was unclear how successful the new rate, which will be published by the Federal Reserve Bank of New York, would be, since regulators can only press banks to participate – not their customers.
Now, however, participants have no choice.
On Thursday, the U.K. Financial Conduct Authority announced that the London Interbank Offered Rates will be phased out by 2021. So even if banks or their customers want to use it, it will not be available.
Andrew Bailey, the FCA’s chief executive, said that banks no longer wanted to participate in setting the rate. The regulator was concerned about the risk that if one or more banks left, others would want to do the same, potentially creating a market disruption.
Libor is used as a reference rate for trillions of dollars around the world, including, in the U.S., leveraged loans and collateralized loan obligations.
Replacing it is going to be a bigger challenge for CLOs than for loans.
For one thing, loans typically have a fallback option of the Federal Reserve's prime as a reference rate. Also, the loan market's trade group, the Loan Syndications and Trading Association, has been working with regulators and other parties for a solution, while the CLO market is more decentralized (each CLO is an individually negotiated fund, Wells Fargo noted in a report published Thursday).
The LSTA said in its own July 21 newsletter that, should Libor be phased out, new credit agreement documents could be drawn up stipulating an alternative reference rate. The LSTA noted, however, that “[loan] industry discussions are just beginning, and any decision and transition process would be counted in years.”
However CLOs, as individually negotiated funds, can only make changes from unanimous consent of investors across the tranche classes in a portfolio. Such a maneuver “could become contentious, as investors would likely look to maximize any advantage posed by rate differences,” according to analysts at Wells Fargo. In a report published Thursday, they noted that even locating all investors in a deal could be problematic.
"Many CLO indentures appear to be largely silent on the issue of a vanishing Libor,” Wells Fargo notes in its report.
And in the absence of unanimous approval, existing deals could maintain ties to Libor since it will likely still be published in some capacity. (It is currently overseen by Intercontinental Exchange Inc., and has even been adapted to include some dealer transaction data to derive rates).
Some CLO managers may have anticipated the potential end to Libor by negotiating a “base rate” amendment allowance that could be approved for individual tranches by a majority of the noteholders in each particular class. “Majority approval may still be difficult, but can smooth out operational difficulties in amendments, as well as allowing for an easier approval process,” the Wells report states.
The ARRC-recommended rate will use data from tri-party repo market activity as well as inter-dealer transactions cleared through the Depository Trust & Clearing Corp.
One drawback is that it will be based on overnight rates, not the one- to three-month maturities for which the Libor benchmarks are estimated. But in a presentation by the ARRC in June, the committee noted that day-to-day and quarterly-end volatility will be smoothed out by overnight index swap contracts that will use the quarterly compound average of the overnight rates (and possibly exclude the quarter-end numbers).