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Let's talk: Replacing Libor ‘crazy,’ but procrastinating worse

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Like many who’ve spent more than two decades in the asset management industry, Paul Norris thinks doing business in capital markets without the benefit of Libor is almost unthinkable.

“You’re talking about trillions of dollars in assets that will be impacted. It is so woven through global finance,” he told Asset Securitization Report in a recent interview. “To get rid of it is crazy. But we have to work under the assumption that we will.”

It may seem the problem is far off, given that the U.K. Financial Conduct Authority has announced the phase-out of the London interbank offered rate won’t take place until 2021. But Norris is among those believing that it’s not too early to discuss what the future might hold for the loss of the widely used benchmark.

“It will be interesting,” he said, “if at the ABS East conference [in Miami] we’ll hear some chatter about it.”

Norris sat down with ASR to discuss how Libor replacement should proceed, as well as his own plans as managing director and head of structured products at investment management firm Conning. Conning provides institutional investors with IG and below-IG credit products including collateralized loan obligations, the latter its Octagon Credit Investors subsidiary. Octagon has issued three new deals and refinanced eight others in an extremely busy year.

Norris joined Conning earlier this year following a five-year stint at alternative asset manager Mariner Investment Group, where, as a portfolio manager, he focused on mortgage derivatives for an affiliated hedge fund. He also once served as director of both mortgage and nonmortgage investments at Fannie Mae.

What are your fourth-quarter plans for Conning?

No expansion per se. Of the asset classes we have been focused on, much of that will remain the same, although we will be a little more involved in the esoteric area such as shipping containers, railcar, aircraft leases, etc. We like that asset class, as we can “sell” liquidity, since we’re a “buy and hold” for the most part. CMBS will be a focused as well, and for CLOs, for the most part the types of clients we work with will want to be focused on the top part of the stack, the triple-A tranches of deals. We will be investing in good managers that have good track records. We will be focused on the triple-A portion of the capital stack while Octagon will focus on the bottom of the stack.

What is driving client interest in esoterics?

For those asset classes, it’s the ability to earn a higher return in exchange for giving up some liquidity. For example, whether it’s a seasoned CMBS or single-A [rated] esoterics, these compare well versus investment grade corporates. [Investment grade] corporates will yield five-year swap plus a spread of around 60 basis points, while you could invest in a single-A [rated] rail container or a CMBS A at a spread of 100 to 160 basis points more than a similar corporate. It’s not like our whole portfolio is going to revolve around esoterics, but when we can get paid and earn a higher yield, that makes a lot more sense.

What is the general mood for structured finance investors?

Generally, with spreads being tight and yields being low, we’re recommending a defensive posture. We generally want to focus on assets that are five years and that amortize and deleverage. We don’t recommend buying assets with 10-year spread durations, given how tight spreads are.

Are there any particular asset classes to avoid that?

I don’t want to comment on any particular asset class, but I would say what we’re wary of is stuff that has really long spread duration. If there is a 25 or 50 points spread widening in a long-spread duration asset [over a shorter-term note], that leads into a pretty large price decline. We want to be pretty careful about assets we’re buying. And now with worries about hurricanes and long-term exposures in structured deals, that defensive positioning is pretty prudent.

How do you see the CLO market developing for investors? There has been a larger-than-expected demand for mezzanine paper this year, for example.

Not for us. The types of clients Conning works with are focused on the AAA and AA CLOs due to the flatness of the credit curve. We have seen credit spreads flattening across other CLO and other sectors like CMBS where BBB and BB has flattened to multi-year tights so we want to stay up higher in the structure. In addition those investors benefit from staying up in capital structure as they achieve better risk-based capital treatment. They are sensitive to ratings, as well as how much yield they are going to earn, so AAA and AA makes the most sense for insurance clients right now, rather than investing further down the capital structure.

Many managers are offering deals with riskier asset allowances and covenants, such as extended reinvestment periods. Is that shifting what your clients are seeking?

You can expect us to stay plain vanilla right down the middle. We’re not going to take undue risk in CLOs, we’re going to focus on good managers.

How do you assess the best qualities in a CLO manager?

It’s both qualitative and quantitative. You assess their skill level as a manager, do they have history of working through different credit cycles.

Do you expect to see a high level of deals in the pipeline through the end of the year?

I’m pretty shocked by the amount of volume we’ve seen [more than $72 billion in new-issue CLOs, and $120 billion in refinancings/resets]. I would expect a slight slowdown in the fourth quarter, simply because I don’t know how much more refinancing there is to be done. From the quarterly pace we’ve seen, I don’t expect as much heading into the fall.

How are investors preparing for the long-term phase-out of Libor?

There has been surprisingly very little talk about it. There have been deals across the spectrum where managers are putting in language to protect themselves in case Libor goes away. But it’s product by product. Everyone should be concerned, but it’s hard to get conversation around it with it being so far off.

It will be interesting if at the ABS East conference [in mid-September] we’ll hear some chatter about it.

What kind of replacement rate do you think investors would prefer; for example, repo overnight rates that the Fed is discussing?

I think it’s ultimately up to the banks, and unfortunately we’re along for the ride. We look to the investment banks and those that set the Libor rate, and look for leadership from them on what they are going to be doing. From an industry perspective, it behooves us to ask banks what plans are.

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