Libor transition stokes sales of risky corporate debt
Wall Street’s shift away from Libor is fueling sales in the red-hot market for bundles of risky corporate loans.
Managers of collateralized loan obligations—securities made up of bundled loans with junk credit ratings—are rushing to close deals ahead of the year-end move away from the London interbank offered rate. The interest-rate benchmark underpins trillions of dollars of financial contracts but was scheduled for phaseout after a manipulation scandal.
That is helping push CLO sales to records. U.S. issuance topped $19.2 billion in August, a monthly record in data going back a decade, according to S&P Global Market Intelligence’s LCD.
That record came during what is typically a slow month for the market, a sign managers are pushing to finish deals ahead of Libor’s expiration, analysts said. Some CLO documents lack language covering the changeover to a new interest-rate benchmark, which could spark disruptions as the new year approaches.
Rather than wait to see how the transition shakes out, CLO managers are taking advantage of recent investor demand and closing deals if possible, said Joe Lynch, global head of noninvestment grade credit at Neuberger Berman, which manages and invests in CLOs.
“Most managers plan to issue one more CLO before year-end and will likely pursue a deal in the near-term to avoid any potential disruptions that might come from the Libor transition," he said.
A strong U.S. economic recovery and support from the Federal Reserve has improved the prospects for many low-rated companies borrowing through the leveraged loan market, which is often used by private-equity firms to finance acquisitions. That marks a reversal after the pandemic’s outbreak fueled worries about mass defaults and sent prices for riskier debt plummeting in 2020.
The trailing 12-month default rate for the S&P/LTSA leveraged loan index fell to 0.47% in August—the lowest level since March 2012.
That recovery has helped spur investors’ demand for CLOs, which are the largest buyer of leveraged loans. As of August, sales of new CLOs in the U.S. in 2021 have surpassed $111 billion, according to LCD—on pace to pass 2018’s record of around $129 billion.
Many expect new CLO sales to remain elevated in September as issuers try to finish deals ahead of the transition, said Bank of America analysts in an August note. They expect new CLO sales tied to Wall Street’s preferred replacement, the Secured Overnight Financing Rate, or SOFR, to begin in the fourth quarter.
A wave of CLO refinancings this year allowed some managers to include fallback language shifting to SOFR in their documents, analysts said. But for other deals, CLO managers and investors must negotiate that changeover, which could create conflicts if they have different rate preferences.
Disruptions to the transition could increase the extra yield, or spread, that investors’ demand to hold triple-A rated CLO debt during the fourth quarter of this year, depending on how quickly the loan market transitions and how new CLO deals and investors position themselves, said Citi analysts in a June note.
SOFR is based on the cost of transactions in the market for overnight repurchase agreements, where large banks and hedge funds borrow or lend to one another using U.S. Treasurys as collateral. Unlike Libor, which tends to rise during periods of market stress, it doesn’t adjust for shifts in credit.
During last year’s spring selloff, the difference between three-month Libor and SOFR rose to 1.4 percentage points at its peak, according to BofA. That means CLO debtholders received a higher rate than what they would have if their bonds were linked to SOFR.
“This is particularly important for [triple-A CLO bondholders] where the reference rate [makes] up a significant portion of the interest rate," said the bank’s analysts in a note.
The move away from Libor also means that some CLO securities may have a different benchmark rate from the loans in their collateral pool. That makes it more difficult for investors to protect their holdings against fluctuations in interest rates and underlying loan prices.
“We anticipate that it will take the market a little time to digest [new] issuance when the shift to SOFR occurs in the new year," said Serhan Secmen, head of CLO investments at Napier Park Global Capital.
This story has been published from a wire agency feed without modifications to the text