The other Libor problem for CLOs: Mismatch between assets, liabilities
Libor’s eventual demise isn’t the only kind of headache this benchmark is giving the CLO market. Even as they start to consider a suitable replacement, managers of collateralized loan obligations are dealing with a more immediate problem: A divergence between the one-month and three-month London interbank offered rates is eating into their profit margins.
The floating-rate securities issued by CLOs pay rates pegged to three-month Libor, while the leveraged loans that collateralize them can be tied to one of four different rates, ranging from one-month to six-month Libor. What’s more, corporate borrowers typically have the ability to switch from one Libor rate to another from month to month.
For the better part of a decade, the potential mismatch did not matter much, because there was relatively little difference between one-month and three-month Libor. But since last October, this difference has widened from just 10 basis points to as much as 45 basis points in mid-May, as three-month Libor increased more than did one-month Libor. The difference, or spread, has since narrowed a bit, to around 30 basis points.
No surprise, as the cost of borrowing at a rate benchmarked to three-month Libor has risen, more corporate borrowers have switched to one-month Libor, lowering their funding costs. Yet CLOs continue to pay interest on their securities based on three-month Libor.
Over half of U.S. leveraged loans (57%) held by CLOs now reference one-month Libor, according to S&P Global Ratings.
This has whittled away at the “excess spread” in CLOs – essentially a manager's profit margin – because there is less cash left over at the end of each quarterly payment period. These leftover funds go to the most subordinate securities issued by CLOs, known as the “equity,” which is typically held at least in part by managers themselves.
“If you assume all rated CLO bonds are priced at three-month Libor and half the assets to one-month Libor, then that mismatch is borne entirely by equity and should amount to about a 1% decrease in yield,” said Berkin Kologlu, a senior portfolio manager at Angel Oak Capital Advisors.
For now, Kologlu said, CLO managers should still earn enough on their loan portfolios to at least pay the interest on rated tranches of CLO securities. So equity holders are the only ones getting squeezed.
Two things could worsen the situation, however. The spread between one-month and three-month Libor could widen further or more corporate borrowers could switch to one-month Libor.
If either happens, there’s not much CLO managers can do. They have no way to compel their own investors to accept a different benchmark (and a lower yield).
Particularly for senior CLO noteholders, “it’s a nonstarter,” said Robert Villani, a partner at the law firm Clifford Chance. Managers “can’t go there,” he said.
Holders of senior, triple-A-rated CLO notes are the most reluctant because they have the most to lose. Switching to one-month Libor would reduce the interest rate on these securities, which currently averaged 103 basis points, by one-third.
Villani says managers are more likely to have successful negotations with junior noteholders. On the more subordinate, double-B-rated notes, a 30-basis-point swing on the in CLO soread would be far less impactful on their average spread price that averaged 567.8 basis points in May (according to Thomson Reuters LPC).
CLO managers have more to worry about than shrinking profit margins, however. The wider spread between the two benchmarks is causing many deals to run afoul of various tests designed to protect investors, such as the minimum weighted average between cost of funds and loan proceeds or the cushion needed on returns to cover interest costs.
Managers' profit margins are being eroded by a number of factors, so concerns about declining excess spread are nothing new.
Not so interest coverage ratios, however. Wells Fargo noted in a May report that this metric is currently at the "lowest level in post-crisis history."
Analysts at Wells Fargo used an “extreme” scenario on a 2016 vintage CLO to see what would happen if all of the loans used as collateral switched to one-month Libor, when this benchmark was at its peak level of May. They determined that the CLO would pass its interest coverage test, but only barely; the interest-coverage cushion fell by 18 basis points to 109%, still above the minimum cushion of 105%.
Some managers are feeling more pain than others.
Ivy Hill Management, which manages middle-market CLOs, saw a 60-basis-point reduction in the weighted average spread levels on its deals as borrowers whose loans they held switched to one-month Libor, according to managing director Stephen Alexander. (Alexander made his remarks at a roundtable event hosted by S&P, which published a transcript of the event n May.)
The CLO market has been here before, briefly. In 2008, at the height of the financial crisis, there was a 100-basis-point spike in three-month Libor. According to S&P, it caused 7% of CLOs outstanding at the time to fail their interest coverage tests early in the fourth quarter of that year, resulting in interest payments diverted from CLO equity and junior notes to pay principal on the senior notes.
The crisis dissipated within a quarter as the spread quickly returned to more typical levels and largely stayed there until last October.
While there’s little CLO managers can do to mitigate the impact of Libor mismatch on existing CLOs, some new deals issued since March allow managers to switch benchmarks, according to S&P. It’s one of many “equity friendly” features that managers have been able to negotiate as a result of the strong demand for CLO securities, including fewer restrictions on purchasing covenant-lite loans and looser cushions on spread tests and asset quality.
Not every manager has been successful in securing the ability to switch benchmarks in new deals, however.
“Unless the basis between the one- and three-month rates flattens, we anticipate this could be an ongoing source of tension between equity and debt investors,” S&P stated in the May report.
There are other potential solutions.
Neeraj Shah, a senior manager at EY, thinks CLO managers might consider negotiating for the ability to switch benchmarks under limited circumstances, such as sudden hitting a threshold for the percentage of assets paying one-month Libor.
“Another solution could be to put basis hedges on top of your deal,” he said at an industry conference in May, “but that could be expensive given the widening of the basis right now.”
Even if holders of senior CLO securities were to agree to switch their benchmark to one-month Libor, it’s not clear how the payments would be calculated. Interest on the securities could still be paid quarterly using a blended one-month note average over the course of the quarter; alternatively the interest rate on the CLO securities could be reset monthly and paid monthly.
“But to the extent that there were three-month loans in the deal, there would need to be a cash flow smoothing mechanism,” one market observer said. “There are a lot of variations on the possibilities out there."
The problem is pretty speculative, however. “Equity investors do not want to lose return, and note investors want three-month Libor paid quarterly,” this person said. “So at the moment, there is somewhat of a standoff.”