LCM's next U.S. CLO has a fix for Libor mismatch

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LCM Management's next U.S. collateralized loan obligation allows the manager the option to change the benchmark rate for interest payments to noteholders.

Alternative benchmarks are a hot topic as participants prepare for the possibility that the London interbank offered rate will no longer be available in a few years. But the language in offering documents for the $409.9 million LCM 28 Ltd. solves a more immediate problem: the mismatch created when loans used as collateral switch benchmarks from three-month Libor to one-month Libor.

Leveraged loans typically allow borrowers to switch between three-month and one-month Libor, but CLOs do not. As a result, a divergence between the two benchmarks this year has been eating into the profits of CLO managers. Loans in CLO portfolios are increasingly switching to one-month Libor, reducing interest payments, while CLO notes remains pegged to higher three-month Libor.

But LCM 28 Ltd. has the ability to peg payments to holders of the senior tranche of notes to either one-month Libor, three-month Libor or "any other applicable reference rate,” according to a presale report published by Moody's Investors Service.

The report does not indicate the circumstances under which a particular benchmark is to be applied; whether it is a unilateral choice by the manager, a joint decision with noteholders or through a spread or interest-rate test covenant trigger.

LCM 28 will issue $244 million tranche of notes rated triple A by Moody's and S&P Global Ratings with an assumed coupon of three-month Libor plus 115 basis points. Based on Oct. 9 closing rates, that coupon would be 2.535% (2.42% plus 115 basis points), compared to a 2.402% rate that would be derived from one month Libor's Oct. 9 rate (2.287%).

The one-month/three-month rate discrepancy has traditionally been narrow, inside of 10 basis points throughout most of the post-crisis era. But this year it has been as wide as 45 basis points.

The resulting reduction in interest payments on CLO collateral put some deals at risk of breaching covenants for minimum interest-rate coverage as well as minimum weighted average spreads, previous reports from Wells Fargo and S&P Global Ratings have indicated.

Concern over the one-month/three-month rate spread has softened over the summer, with the rates having since narrowed (within 14 points on Oct. 9).

In addition to alleviating the divergence of the two benchmarks, a note coupon option for "any applicable reference rate" open to LCM could potentially be tapped to choose a non-Libor rate in the event that Libor is phased out after 2021, when U.K. regulators will no longer require a panel of global banks to submit daily quotes on interbank offering rates used to set the Libor rates. (The deal has an expected weighted average life of nine years).

Plans for an alternative rate for corporate loans, CLOs and other debt instruments remain embryonic, although the New York Federal Reserve - which this year began publishing an alternative overnight rate for derivatives, the secured overnight financing rate (SOFR) - has begun work on developing a term rate based on SOFR.

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