By the Numbers

A slow LIBOR transition challenges CLOs

| January 20, 2023

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.

In less than six months LIBOR officially goes to the grave, But with a large share of CLO assets and liabilities still indexed to the expiring benchmark, the operational and legal risks for CLO manager are mounting. The slow pace of the LIBOR transition has affected all CLOs, with those in the post-reinvestment period more exposed to the risks. The transition may also reduce the excess spread available to some equity investors due to lower credit spread adjustments being applied to the new benchmark.

The institutional loans that comprise the collateral and the CLO securities themselves both need to move to a new benchmark rate by the end of June. The share of loans or CLOs with no formal fallback language is currently very small. The legacy CLOs that lack viable fallback language can transition from LIBOR to term SOFR under the provisions of the LIBOR Act, which incorporates the ARRC-recommend credit spread adjustments.

Most outstanding CLO contracts already include fallback language that outlines a process for transitioning to a new rate. However, the collateralizing loan agreements between the borrowers and lenders, or loan agents, have to be amended to replace LIBOR with an alternative rate. Some technical and operational changes have to be implemented even when hardwired fallback language is already in place. This alone may create a legal and administrative bottleneck for institutional borrowers, their agents, and CLO managers as the LIBOR termination date approaches.

The problem for CLO investors and managers is that the fallback language for the collateral and for the securities is often different and can vary from the fallback language endorsed by the LIBOR Act.

  • Over 50% of outstanding institutional loans benchmarked to LIBOR have fallback amendments that  require a consent vote among the lenders, according to the Loan Syndications and Trading Association (LSTA).
  • Only two-thirds of S&P-rated broadly syndicated loan (BSL) CLOs incorporated the Alternative Reference Rate Committee (“ARRC”) recommended fallbacks.

CLOs in the post-reinvestment period are more exposed to the LIBOR transition risk

The BSL CLOs have an average of 21% of SOFR-indexed loans today, indicating a large amount of work needs to be completed in the next five months. To make matters worse, static CLOs and CLOs in the post-reinvestment period all have lower-than-average SOFR loan exposure (Exhibit 1). A manager has limited ability to trade loans when a CLO is in the post-reinvestment period, a feature making those CLOs solely reliant on their managers to complete the LIBOR transition. However, CLOs during the reinvestment period offer managers additional ways to reduce the LIBOR exposure in the next few months, for example, by trading from LIBOR to SOFR loans. Those CLOs having more than 40% exposure to SOFR loans today were all issued in 2022, with the reinvestment period ending in 2025 and thereafter.

An additional 25% of outstanding BSL CLOs will enter the post-reinvestment period this year, of which half will be in the post-reinvestment period by June.   The post-reinvestment period CLOs will reach 28.6% of all BSL CLOs at the time of LIBOR cessation.

Exhibit 1 A slow-paced LIBOR transition will impact all CLOs

Data reflects 1,749 outstanding U.S. BSL CLOs with an aggregate collateral balance of $846 billion.  Performance as of December 2022. Source: INTEX, Amherst Pierpont Securities LLC

Credit spread adjustments may cause a reduction of excess interest

The ARRC, organized by the New York Fed, recommends that LIBOR be replaced by SOFR as a new benchmark rate plus a credit spread adjustment (CSA). The credit spread adjustment is included because LIBOR is an unsecured lending rate that has a credit risk component while SOFR is a risk-free rate, so LIBOR rates are typically higher than SOFR rates of the same tenor. The recommended CSA to be added to the new SOFR-based benchmark varies by tenor (Exhibit 2), including 11.4 bp for 1-month LIBOR, 26.2 bp for 3-month LIBOR, and 42.8 bp for 6-month LIBOR.

Exhibit 2: ARRC recommended credit spread adjustments

Note: The credit spread adjustment is the 5-year historical median of the difference between LIBOR and SOFR rates for each tenor. The spread was fixed in March 2021.
Source: Alternative Reference Rate Committee

A large share of outstanding CLO debt is LIBOR-based today, but the CSA application is generally robust, and the final rule of the LIBOR Act provides additional transition guidance. According to S&P, approximately 66% of outstanding BSL CLOs include ARRC fallbacks, so a 26 bp CSA will apply when tranches transition to the SOFR rate. An additional 31% of BSL CLOs have fallbacks that give managers limited discretion to select a replacement rate, but managers may have incentives to choose SOFR and the ARRC CSA given the statutory safe harbor provisions provided under the final rule of the LIBOR Act.

By contrast, the CSA application on the CLO asset side has been a bit messy. The outstanding institutional loans that have hardwired amendments incorporating the ARRC fallbacks will transition by June with a direct application of ARRC CSA. But many loans use negotiated amendments that transition with a lower CSA than those outlined in ARRC fallbacks, for example, a flat 10 bp. In addition, many new institutional loans in 2022 used a CSA scale lower than the ARRC recommends, with 10 bp, 15 bp or 25 bp spread adjustments for 1-month, 3-month and 6-month tenors being frequently utilized. Some new transactions for SOFR-based loans make no mention of a CSA, implying it was incorporated into the loan credit margin (Exhibit 3). The trend continues in 2023. For seven new loans issued year-to-date, only one loan incorporated the ARRC CSA.

Exhibit 3: A small share of new issue loans in 2022 used ARRC CSA

Source: LCD Pitchbook, Amherst Pierpont Securities LLC

The various credit spread adjustments due to different types of fallbacks may cause a reduction in CLO excess spread, all else equal. CLO equity investors may be particularly sensitive to the transition given the potential lower equity yield.

Racing to the 100% SOFR exposure

CLO managers need to speed up their LIBOR transition work, but managers are not on an equal footing today. Most CLO managers have deal exposures ranging from 15% to 30%. It is worth noting a few large managers have trailed their peers in the progress to date, implying a large workload ahead (Exhibit 4). Nevertheless, investors need to monitor all managers’ progress carefully in the next few months.

Exhibit 4:  A few large managers have a heavy workload ahead

Data reflects 1,749 outstanding U.S. BSL CLOs with an aggregate collateral balance of $846 billion. Performance as of December 2022.
Source: INTEX, Amherst Pierpont Securities

Caroline Chen
caroline.chen@santander.us
1 (646) 776-7809

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