Libor Transition causes risky corporate debt sales

This is helping drive CLO sales to records. U.S. issuance topped $ 19.2 billion in August, a monthly record from a decade ago, according to the S&P Global Market Intelligence LCD.

That record came during what is normally a slow month for the market, a signal that managers are pushing to end deals before Libor expires, analysts said. Some CLO documents do not have a language that covers the change to a new interest rate benchmark, which could cause changes as the new year approaches.

For CLO portfolio managers on Wall Street, advancing bids allows them to earn new revenue, rather than waiting and seeing how the Libor transition affects the market. Investors involved in CLO transactions can obtain relatively higher fixed income returns with known settlement documents, sometimes including a language scheduled for the December deadline.

Instead of waiting to see how the transition is saved, CLO executives take advantage of recent investor demand and close deals if possible, said Joe Lynch, head of global non-investment credit at Neuberger Berman, which manages and invests in CLO.

“Most managers plan to issue one more CLO before the end of the year and will likely try a short-term deal to avoid possible disruptions that could result from the Libor transition,” he said.

A strong U.S. economic recovery and Federal Reserve support have improved the outlook for many low-lending companies through the leveraged lending market, which is often used by private equity firms to finance acquisitions. This marks an investment after the outbreak of the pandemic fueled concerns about massive defaults and sent the prices of a riskier debt to fall by 2020.

The 12-month final delinquency rate for the S & P / LTSA leveraged lending index fell to 0.47% in August, the lowest level since March 2012.

This recovery has helped drive CLO demand from investors, who are the largest buyer of leveraged loans. In August, sales of new CLOs in the U.S. in 2021 topped $ 111 billion, according to LCD, at a rate to break the 2018 record of about $ 129 billion.

Many expect new CLO sales to remain high in September as issuers try to end operations ahead of the transition, Bank of America analysts said in an August note. They expect new CLO sales tied to Wall Street’s preferred replacement, the overnight secure financing rate or SOFR, to begin in the fourth quarter.

A wave of CLO refinancing this year allowed some managers to include the alternative language that passed to SOFR in their documents, analysts said. But for other offerings, CLO managers and investors have to negotiate this change, which could create conflicts if they have different types of preferences.

Transition interruptions could increase the additional, or differential, performance required by investors to maintain a triple-rated CLO debt during the fourth quarter of this year, depending on how quickly the lending market moves and how position new CLO businesses and investors. , Citi analysts said in a June note.

SOFR is based on the cost of market transactions for overnight repurchase agreements, where large banks and hedge funds lend or lend to each other using U.S. treasuries as collateral. Unlike Libor, which tends to increase during periods of market stress, it does not adjust to credit changes.

During last year’s spring sales, the gap between Libor and three-month SOFR rose to 1.4 percentage points at its peak, according to BofA. This means that CLO debt holders have received a higher rate than they would have if their bonds were tied to SOFR.

“This is particularly important for [triple-A CLO bondholders] where the reference rate [makes] it raised a significant portion of the interest rate, ”bank analysts said in a note.

Libor’s removal also means that some CLO securities may have a different reference rate than loans from their guarantee fund. This makes it more difficult for investors to protect their holdings against fluctuations in interest rates and underlying loan prices.

“We expect that the market will take a while to digest [new] issue when the change to SOFR occurs in the new year, ”said Serhan Secmen, head of CLO investments at Napier Park Global Capital.

Write to Sebastian Pellejero to [email protected]