By the Numbers

A slow LIBOR transition may add credit risk to CLOs

Caroline Chen | March 3, 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. This material does not constitute research.

Roughly 75% of leveraged loans and 85% of rated US CLOs are still indexed to LIBOR, according to a recent S&P analysis. And beyond risks posed by legal and operational bottlenecks, CLO investors face risk from loans that reset to different terms after June.

Loans that fail to execute an amendment by June 30 may have their benchmark rate reset to the prime rate. Given the large amount of debt, some borrowers may be vulnerable to a high prime rate.
The credit spread adjustment (CSA) may differ between the asset and liability sides of a CLO, potentially reducing the excess spread. According to a recent S&P rating impact analysis, the ‘BB’ or lower-rated tranches are most likely to suffer if negative rating actions are taken.

Loan agreements executed before 2021 may add the credit risk of CLO collateral

According to S&P, the benchmark transition event and CSA provisions were hardwired into the vast majority of loan credit agreements executed after the Financial Conduct Authority (FCA) announced the LIBOR cessation in March 2021. In those agreements, SOFR is the prevailing replacement rate, and CSA provisions typically follow the ARRC recommendations. Credit agreements executed prior to the FCA’s official announcement, on the other hand, were less comprehensive. In most cases, a fallback language does not specify a new benchmark rate. The new benchmark rate may be based on the outcomes of one of the following situations.

Loan agent’s sole authority to amend rates
Loan agent and borrower good faith negotiation
Required lenders’ consent

Many old agreements state that the prime rate will be applied during any interim period between LIBOR cessation and the adoption of a new benchmark rate. Furthermore, some hardwired loan agreements also require amendment to transition. According to S&P’s analysis of a sample of credit agreements, if an amendment would not be executed by June, the replacement rate may default to the prime rate as well.

The spread gap between the prime rate and 3-month LIBOR from 2019 to 2022 has been around 2.85% (Exhibit 1). The replacement of a higher prime rate due to a slow LIBOR transition may pose additional credit risks to CLO investors, as some borrowers in the collateral pool may be vulnerable to an increasing debt payment.

Exhibit 1: Spread gap between Prime Rate and 3M LIBOR averaged 2.8%

Note: Data reflect index daily closing price from Jan 2019 to Feb 2023.
Source: Bloomberg, Santander US Capital Markets LLC

A lower CSA may reduce excess spreads, and negative rating actions may follow

The CSA application during transition looks much more robust on the CLO liability side than on the asset side. CLOs issued after January 1, 2022, or 15% of the S&P-rated CLO universe, already have CLO bonds benchmarked to CME Term SOFR. The vast majority of remaining outstanding CLOs, or 60% of the S&P-rated universe, have robust hardwired fallback language in their CLO documents that will cause CLO bonds to transition to term 3-month SOFR with a 26 bp CSA. But CLO documents for deals issued in 2017 and 2018 or earlier had weak fallback languages. The LIBOR Act of 2022, on the other hand, may incentivize CLO managers to select CME Term 3-month SOFR with a 26 bp CSA for the safe harbor provisions.

The CSA applied on the CLO asset side varies, and in most cases, a lower than 26 bp CSA applied that may result in reduced excess spread, all else being equal. Out of 321 new issue loan facilities in 2022, only 16 adopted the ARRC recommended CSA, according to LCD Pitchbook. The vast majority of new issues had CSA less than 26 bp or no CSA. In some cases, a no CSA may occur simply because a post transition rate is an all-in interest rate with a CSA baked in.

According to the S&P rating impact analysis published in June 2022, the excess spread reduction resulting from the LIBOR transition may hurt a small portion of ‘BB’ or lower rated tranches (Exhibit 2). It is worth noting that CLO managers are not new to managing the basis risk in CLO transactions. Most CLO assets are indexed to 1-month LIBOR, while CLO tranche debt are indexed to 3-month LIBOR. The S&P rating impact analysis does not factor in manager intervention for conservative modeling assumptions.

Exhibit 2: ‘AAA’ & ‘AA’ CLOs less impacted by excess spread reduction

Note: The rating movement data represent US BSL CLOs only. The sample of transactions in S&P analysis include 686 CLOS with approximately 3700 tranches. About 96% were BSL CLO and 95% sampled transactions were still in reinvestment period as of June 2022. An average tranche rating movement of -0.10 indicate that 10% of that rating universe would see its rating lowered by one notch or 5% by two notches downgrade. A complete S&P analysis is here.
Source: S&P, Santander US Capital Markets LLC

A 4% monthly LIBOR transition progress remains slow

BSL CLOs today have an average of 25% of SOFR-indexed loans in their collateral pool, a 4% increase from the prior month (Exhibit 3). At the current pace, most CLOs may not have completed their LIBOR transition by June. The clock is ticking, and the risks are rising.

Exhibit 3: Current transition pace exposes all CLOs to risks

Note: Data reflects 1749 outstanding US BSL CLOs with an aggregate collateral balance of $840 billion as of February 2023.
Source: INTEX, Santander US Capital Markets LLC

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

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