The recent and ongoing upheaval in Libor rates is producing divergent outlooks on debt and equity positions in CLOs, says the Loan Syndications and Trading Association.
In its weekly newsletter Friday, the LSTA noted that the sharp rise in the Libor benchmark rate over the past month has improved the yield environment for the floating-rate notes in collateralized loan obligations – particularly the ‘AAA’ notes atop the capital stack.
Meanwhile, equity positions are taking a hit with the climbing Libor rate, in terms of yield as well as the decline of guaranteed yield with the elimination of rate floors in some new leveraged loan issues.
“While CLO debt tranches are benefiting, CLO equity is being squeezed,” the LSTA newsletter stated.
For ‘AAA’ note holders at the head of the capital stack – and first in line for the cash-flow waterfall of returns and borrower payments – the fast rise of three-month Libor and other benchmarks since July is producing a rapid gain in yields. Citing a recent Morgan Stanley report, the LSTA stated that a “generic” U.S. CLO ‘AAA’ note paying Libor plus 150 basis points offered only a 2.13% annualized yield when Libor was 63 basis points in April. At 79 basis points, “the ‘coupon’ jumped to 2.29% - a 7.5% rise in just three months,” wrote the LSTA.
In contrast, the senior loan industry trade group noted, cash payments to equity are reduced by roughly 0.9% for each 10 basis point increase in Libor rates (if the collateral pool has an average floor of 90 basis points.”
With Libor floors in place, equity holders in CLOs have had a guaranteed yield on the gap between low rates and the rate floors that have typically been 75-100 basis points in recent years.
But two July leveraged loan deals, involving computer chipmaker Avago Technologies and food products company Pinnacle Foods, each company issued deals without Libor floors in response to the fast-rising three-month Libor. The benchmark rate this week surpassed the yield on three-year U.S. Treasury notes for the first time since October 2012, and reached its highest point (81 basis points) since May 2009, according to Reuters.
“Don’t expect this to change anytime soon,” the newsletter stated. “Morgan Stanley notes that the decline in demand for short term paper is unlikely to be reversed, leading to higher LIBOR in the long term.”
According to Reuters, 10% of leveraged loan issuance in July lacked Libor floors.
In an example spelled out by Thomson Reuters-LPC, an environment in which three-month Libor was 25 basis points and floors averaged 1%, “a 10x leveraged CLO would have seen the cash payments to equity investors increase by roughly 7.5[%],” the LSTA noted. “In contrast,” a recent report from Morgan Stanley figured that “if the collateral pool has an average floor of 90 bps, each 10 bps increase in Libor reduces the annual cash distribution to CLO equity by roughly 0.9[%].”