The Big Idea

LIBOR transition and the looming basis risk in CLOs

| September 24, 2021

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The era of new LIBOR loans and new LIBOR CLOs ends on December 31 this year. And the next day the era of SOFR and other indexed loans and CLOs begins. The transition stands to bring plenty of basis risk to the CLO market. Legacy CLOs will have a rising share of their portfolios in SOFR loans, and new SOFR CLOs will start investing in a loan market dominated by legacy LIBOR. Then on June 30, 2023, a lifetime away in capital markets time, LIBOR goes away altogether. Amherst Pierpont brought together a panel of experts to discuss the dates, details and twists and turns in this transition.

The participants: Steven Abrahams, Head of Investment Strategy at APS, and moderator; Meredith Coffey, Senior Vice President and Head of Research at LSTA; Michael Koegler, Managing Principal, Market Alpha Advisors; Adam Schwartz, Head of CLOs and Structured Credit, APS.

An edited transcript follows:

Dates, timelines and readiness

SA: Meredith, I want to start with you. And I want to make sure we know what is ahead. When does the issuing of new LIBOR leveraged loans stop and when do legacy LIBOR loans ultimately have to switch to something else?

MC: Great. Well, thank you, Steve, and thank you for having me here today. As folks probably do know, there are different end dates between when you have to stop LIBOR origination and when legacy LIBOR contracts have to switch to a replacement. New LIBOR origination must stop by year-end 2021. According to the US regulators, that is the drop-dead date. But in reality, the regulators have told the banks that they want to see meaningful progress toward new non-LIBOR origination well before that drop-dead date. So, they want to see new non-LIBOR loan origination in the fourth quarter 2021. The banks have told us they’re planning to comply. So we’re really expecting to see non-LIBOR loan origination really ramp up in the coming weeks and quarters.

SA: What about the deadlines for CLOs?

MC: The timelines, the dates are the same for CLOs. So, no new LIBOR CLOs issued after year-end 2021. And legacy CLO liabilities switch from LIBOR to SOFR no later than June 30, 2023. However, there’s a couple of nuances for CLOs. So, first we’re not sure we’re going to see a ton of SOFR loans in the fourth quarter of 2021 because not going to be SOFR CLOs. We might not see a material ramp-up in SOFR CLOs until early 2022. Also, many CLOs have what’s called an asset replacement trigger, which is to say that once 50% of the CLO assets switch from LIBOR to a replacement, the transition process may begin for CLO liabilities. We could see a lot of legacy CLOs transition prior to June 30, 2023.

SA: Meredith, are the loan issuers, the agents, the investors ready with systems for the December 31 deadline? And is there real clarity on what the new index will be?

MC: To be honest, we at the LST have been working on this for going on for years. The vendors are generally ready to handle almost any replacement version of SOFR. And they’re ready to implement most credit-sensitive rates. However, we have heard that not all clients have adopted the most recent release of vendor systems. And the most recent release has the ability to do SOFR and all these other rates. So, if people do not have the most current system release in place, they need to do that ASAP.

The other new thing folks need to know is that entities that invest in loans probably need to have a CME term SOFR license. And this is critical because I think most people did not know this. The CME is making that term SOFR license available for free through 2026. But it does take work to get license. So we suggest that people begin ASAP.

SA: Mike, you are talking to a wide range of people trying to pick a new index. Have they made the pick?

MK: There are some significant differences between SOFR and LIBOR that everyone really needs to understand. SOFR is the secured overnight financing rate based on overnight Treasury repo, which is very actively traded. I think there’s close to a trillion a day, certainly in the high hundreds of billions that trade per day. The version of SOFR where all the liquidity lies is the overnight rate. A lot of market participants would have difficulty in implementing overnight SOFR, either daily, simple SOFR, which is an average, or daily compounded. For that reason, the ARCC endorsed term SOFR. As Meredith said, most of the market is moving towards term SOFR.

The other big problem with SOFR is it has no credit sensitivity. As I said before, it’s truly a risk-free rate. A perfect example of why this is potentially a problem is what happened in March of last year with the onset of Covid. The credit-sensitive rates such as LIBOR or Ameribor or BSBY gapped 120 to 150 basis points while SOFR dropped to one basis point and sat there for months. If you own a SOFR security, you now have a situation where credit spreads are widening and the rate that you’re receiving is going lower.

SA: Adam, you’re talking to the issuers and the investors on the CLO front. On the operational side and the index side, do you think the CLO market is ready for this?

AS: I think CLO investors and issuers are now very aware that this change is coming. I think that the consensus is forming around using term SOFR as the replacement rate. On the operational setup, I think it’s definitely a bit mixed. I think larger institutional investors, large banks, insurance companies, asset managers are definitely already set up to purchase securities that are referencing SOFR and may already be buying those securities in other securitizations or other asset classes. I think we are hearing from some of the smaller institutions, maybe some smaller regional banks, smaller asset managers might be buying only LIBOR instruments. They are not quite ready yet. It’s a combination of updating their own internal systems. I think the upshot really is that the market probably isn’t quite ready yet to process a SOFR CLO, but I think certainly will be into the fourth quarter.

Risk-free rates, credit-sensitive rates and borrower-lender tensions

SA: Mike, you raised a very interesting point a moment ago about the switch from LIBOR, which is credit-sensitive, to SOFR, which is not credit sensitive. I know you’ve had a number of conversations with investors about whether they should ask for compensation for the difference in the response to the index under stress. Adam, have you run into investors or issuers that are worrying about that as well?

AS: I think the answer to that is really “no.” We’ve had asked the question of a number of CLO investors. This topic is much broader than just CLOs, which may be part of the issue. Investors are just not really thinking about thinking about that aspect of it and are much more focused on a topic that we’ll discuss later, which is what the spread adjustment is supposed to be between SOFR and LIBOR.

SA: Meredith?

MC: Sure. It’s important to note that I have two constituents. One is the banks, and one is the institutional investor community. And I would say the responses are very different. The arguments are stronger for credit-sensitive rates in a bank-originated, bank-held, high-optionality markets like revolvers. And I think the arguments for credit-sensitive rates are probably a bit weaker in a funded, long-term asset held by institutional investors.

Going back to the in the beginning of 2000, we have thousands of observations of LIBOR and SOFR. And what we observed is that 70% of the time, the difference between LIBOR and SOFR was between five and 30 basis points. And 6% of the time, it had it widened out to 100 basis points. To be fair, we can absolutely look at the financial crisis where there was a huge gap between LIBOR and SOFR for a time, or we can look at March last year. There is absolutely a tail risk that we could have a market-wide event where a credit-sensitive index would widen and SOFR would narrow. Lenders are giving up an option, investors are given up an option when they go from a credit-sensitive to a risk-free rate. There’s no question about that there is a value transfer, and they should negotiate to be paid for that value. We think and regulators probably think that institutional investors should be able to price capital markets instruments over a risk-free rate. When we look at the institutional market, institutional loans and CLOs, I think people are sophisticated enough to understand the difference between the two and negotiate appropriately.

SA: Mike, you seem very convinced the transition to a risk-free rate is a challenge at the very least and there are some better alternatives to SOFR. What’s your thinking there?

MK: There are some situations where SOFR works very, very well. And then there are other situations where it does not work well. Credit-sensitive rates address a certain problem in the market, when you have assets that are either further down the capital spectrum or lower rated credits. If you now take that type of the security, you put SOFR into it, you have none of that credit protection. People are still trying to grapple with it.

If you’re a borrower and you’re looking at this, your bank comes to you and says, “Okay, we’re going to take your LIBOR loan, and we’re going to give you a SOFR loan. And we’re going to tack on (the ARCC recommended) 26 basis points on the spread. The borrower says, “Hey, wait a minute, the (spot) spread is only eight basis points, I don’t think I should pay 26.”  You also have investors are looking at this, and they’re saying, “Well, I don’t have any credit sensitivity in the index. And I don’t think 26 basis points is enough.” You have this disconnect in the market now.

SA: Mike, you have really kind of laid out in very clear terms what the tensions might be between different participants. Meredith, you’re already seeing a little bit of tension between borrowers and lenders in the loan space. Who is going to win that tug-of-war?

MC: We’re absolutely seeing a situation where borrowers are going to want to pay that eight basis point differential. Why in the world would they pay an above-market rate right now., if you could do live war, and you still can do live or right now? In the loan space, with technicals where they are, borrowers have more power than the lenders right now. And it is going to be a negotiation. You know, lenders, of course, would prefer to get that 20- or 30-basis points historical spread differential, and presumably, if they figured out how to evaluate it, the value of the option of the credit sensitivity. I think it will be messy. I do think it’ll be contentious for a bit of time. But I think it’ll be negotiated.

SA: Adam, as a CLO structurer, you play the role of referee at times between these parties. Are you starting to get a sense that there are people on different sides of this question?

AS: Absolutely. CLO equity investors would argue the adjustments should be the eight basis points and then debt investors are trying to argue that it should be at 26 basis points. It’s going to be a similarly messy process negotiated on a deal-by-deal basis. And the market will just probably come to some consensus as to what that adjustment should be, although it could differ on a deal-by-deal basis. The general thinking in the market right now seems to be that is going to be somewhere in between the spot rate and the 26 basis points.

SA: Adam, Meredith mentioned this optionality, the different behavior of these indices under stress. Is that optionality on the radar people for CLO investors trying to figure out fair value?

AS: Not really, I think people are just purely looking at it in this kind of spot in historical average perspective and not really thinking through thinking through that aspect of it. Okay, super.

The LIBOR sunset

SA: Well, let me touch on one other issue: LIBOR sunset. Meredith, is the legacy loan market set up for a smooth transition on June 30, 2023?

MC: Individually, yes. But collectively, there’s a lot of work left. In the syndicated loan market, there are thousands of loans that need to transition from LIBOR to a replacement rate. If you add bilateral loans, we’re talking about hundreds of thousands. Most loans and the vast majority of syndicated loans do have fallback language. So individually, they’re okay. But we’ve got a collectivity problem. If we see thousands or hundreds of thousands of loans transitioning via fallbacks in the middle of 2023, that’s going to be trying to push an elephant through a window.

We are hearing that a lot of people, instead of waiting, are going to refinance directly into a replacement rate between January 2022 and July 2023. The banks are going to be pushing that because they don’t want to have to deal with thousands or hundreds of thousands of fallbacks at the same time. If you refinance, you can probably refinance at a lower spread adjustment (than 26 basis points) because that’s where the markets are, so there’s an incentive from a negotiation perspective to refinance directly.

SA: Mike, you review the status of CLOs for investors. Do you think the CLOs are equipped?

MK:  There’s fairly robust fallback language. But there is potentially going to be some noise. As Meredith pointed out, it may make sense for borrowers to refinance their loans versus waiting for the lead agent to come in and change the benchmark rate. I think we’re probably going to see a wave of refinancings next year in bank loans. And obviously, that’s going to affect CLO managers.

AS: As Meredith mentioned, CLOs really have to follow the lead of the of the underlying loans.  Especially since so many deals have been refinanced or reset this year, most CLOs have asset replacement percentage concept where they can’t transition until 50% of the assets are referencing a new rate. So the loan market will dictate the timing of the transition there. There are certainly legacy CLOs that have less robust LIBOR replacement language where it may be more at the discretion of the manager, including the discretion of whether or not to include an adjustment. There are some that have no LIBOR replacement language. The vast majority of the market will be fine. But there are certainly some cases that will be messy.

SA:  New York State passed a law this spring designed to help solve some of the hard cases where an existing security never anticipated a permanent end to LIBOR, and many of those hard cases would result in a fixed-rate security. And I know that there’s a similar law now under consideration at the federal level. Has the New York law solved our problems? Or will the federal law, if it passes, solve the problems?

MC: If you have amendment fallback language or hardwired fallback language, you’re not in scope of legislation. There are probably about $30 billion in CLOs in scope. That is a real number, but it is a small part of the $750 billion market. Moreover, because those CLOs now are so old and certainly well within their call period, they can be called if this is catastrophic. The problem as a whole for the CLO market is smaller than it is for other asset classes.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

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