Collateralized loan obligations (CLOs) are multi-faceted transactions involving literally hundreds of parties, so it is no surprise that transitioning them away from Libor will be complicated—in fact, very complicated. The same complexity, however, may actually immunize CLO managers and investors to basis and other risks likely to emerge.
CLOs have parties with widely varying interests on both the asset and liability sides of the transactions. Investors in CLO equity have very different priorities than those investing in the AAA bonds, and CLOs typically securitize 150 more highly bespoke loans.
“In the syndicated loan market, one of the complexities in switching [benchmarks] is having all the syndicate members ready to operationalize” the Secured Overnight Financing Rate (SOFR) that syndicated loans are anticipated to transition to, said Meredith Coffey, executive vice president of research and public policy at the Loan Syndications & Trading Association (LSTA).
Further, there are several methodologies to calculate the SOFR that commercial lenders and CLO investors can choose, or they may opt for Fed Funds or another reference rate altogether. Most of those potential replacements are overnight rates and must be averaged daily between interest payments, operationally much more complicated than term Libor.
“This isn’t Y2K, but very few people’s systems are set up to deal with this kind of stuff,” said Thomas Majewski, managing partner of Eagle Point Credit Management, which invests in CLO securities and has participated in committees organized by the Federal Reserve-convened Alternative Reference Rate Committee (ARRC) to facilitate the transition.
Existing Libor-based transactions have until June 2023 to transition, but all new issues should start using a replacement rate by year-end. Hence new CLOs will likely contain loans priced over a mix of reference rates, some with terms and others averaged daily.
A forward-looking term version of SOFR would greatly simplify the transition from an operational standpoint but appears
Today, SOFR can be calculated in one of four ways, each arriving at a slightly different rate. A simple average of the overnight rate in arrears is the most straightforward, followed by compounded in arrears. However, the arrears averaging must halt before interest-rate period ends, which may vary from loan to loan, to enable accruals to be calculated and interest paid.
The in-advance method informs investors of their future interest payments at the start of the term, similar to Libor, and it avoids the pause at the end. However, it takes the simple or compounded average of daily SOFR over the previous period, raising concerns that it does not accurately reflect the current financial environment.
The ARRC recommends new CLOs begin using SOFR to price notes by Sept. 30, while most loans will remain priced over Libor. In fact, actively managed CLOs, buying and selling assets throughout their shelf lives, will most likely have a mix of loans priced over Libor and/or a variety of replacement rates over the next several years, complicating the task of calculating interest streams.
That presents major operational problems for managers, who must set up systems to track, monitor and report on underlying loans and CLO metrics. It might also inhibit CLO trading, given that trustees must verify a CLO's interest-rate tests remain in compliance as assets are bought and sold out of the portfolio.
Majewski noted that the operational complexity of dealing with multiple, new reference rates will likely be less burdensome for asset managers, whose back-office systems already handle most securities and derivatives. But calculating new reference rates into existing deals could present challenges for banks and custodians that have older, less-nimble loan-administration systems.
And although the new reference rates introduce basis risk. It is likely that managers face a challenge with varied calculations on loan collateral with multiple different reference.
But CLOs have always dealt with basis risk, Majewski noted, with CLOs typically resetting quarterly while their loans reset at different times intervals and over different benchmarks.
“This isn’t Y2K, but very few people’s systems are set up to deal with this.”
Libor volatility may hurt or benefit CLO cash flows, depending on when their assets and liabilities reset relative to the rate shift, Majewski said. He noted working on a CLO when Libor plummeted in 2008 that experienced a “windfall,” while last April Eagle Point’s public fund saw its cash flows drop when Libor approach zero, although its cash flows in January 2021 exceeded the same month a year ago.
In terms of managing the ongoing basis risk, the ARRC has found the basis difference between different SOFR calculation methods to be minimal, and Majewski noted there’s generally little basis risk between short floating terms, such as such as one-month and three-month Libor or SOFR.
“This is really straightforward and much ado about nothing. There’s basis risk already in CLOs,” Majewski said, adding that CLOs’ significant excess spread—typically 150 basis points or more—“makes a mismatch trivial.”
Nevertheless, there will be complications market participants will have to address. For one, CLOs trade on a T+2 basis, so buying debt priced over SOFR in arrears means the investor won’t know what the accrued interest amount is when they commit to a trade.
“It’s just another twist, “Majewwski said, “Either we’re going to have to change the settlement period on CLO debt to T+1, or if we stick with T+2 investors will have to accept that they won’t know the exact accrued interest when they make the trade.”
