The European Central Bank’s latest stimulus program has been a boon for the region’s CLO market in some ways. Issuance of new collateralized loan obligations has certainly picked up since ECB chairman Mario Draghi announced the bond buying program in March.
But there’s a real downside to extremely low or even negative interest rates. Existing CLOs may not earn enough from their euro-denominated assets to pay the interest on the notes that they issue.
In a report published Thursday, Moody’s Investors Service warned that the year-long negative interest environment in Europe – where a flush of cash from the ECB is prompting banks to charge other institutions to park excess liquidity – poses risks to European CLOs.
That’s because, unlike U.S. loan market, where interest-rate floors are the norm, less than half of loans in European CLOs have such safeguards. Most pay interest that is pegged to a benchmark with no floor. This reduces the interest income that European CLOs earn on their assets, “and, in turn, [reduces] excess spread, which helps offset credit deterioration in the event of coverage test failures,” the report states.
According to Moody’s, a median of 50% of collateral in CLOs completed post-crisis have Euribor floors; these floors are weighted average rate of 30 basis points, at least in deals rated by Moody’s. And for European CLOs completed before 2008, the median level of assets with interest rate floors is only 30%.
The notes that CLOs issue to fund their purchases are also pegged to Euribor; so even if assets in the portfolio earn interest, this money might not be used to pay the interest on CLO notes. Moody’s reckons that half of European CLOs completed post-crisis issued notes with interest-floors, though this floor may be zero. And none the CLOs completed pre-crisis issued notes with floors.
“If Euribor is sufficiently negative, CLO notes without zero liability floors are at risk of not receiving any coupon at all,” the report, authored by senior analyst Javier Hevia, states. “European CLO 1.0 senior notes are particularly vulnerable to this risk because they have low spreads over Euribor, typically around 24 basis points.”
Three-month and six-month Euribor rates have been in negative territory for several months. The three-month rate (which was -0.259% as of Wednesday) fell below zero in April 2015. The six-month rate, currently -0.144%, followed suit in November.
The median floor rate on assets in European CLOs completed post crisis 0.95%; for CLOs completed pre-crisis that do have floors, the median is 0.96%. And notes issued by European CLOs have a weighted average floor rate of at least 30 basis points. Thus far, there has been sufficient spread between what they earn on assets and pay out on liabilities to allow them to make interest payments.
By comparison, U.S. CLOs that have a median Libor rate floor of 99.4 basis points. But Libor floors are nearly universal in the U.S.; 93% of senior loans in the S&P/LSTA Leveraged Loan Index providing have floors of between 75 and 100 basis points.