LIBOR transition stocks risky corporate debt sales

Managers of collateralized debt obligations—securities made up of bundled debt with junk credit ratings—are rushing to close deals before the end of the year, away from the rate London Interbank offers. The interest rate benchmark underpins trillion-dollar financial contracts but was set to be phased out after a manipulation scandal.

It’s helping the CLO’s sales hit records. According to the LCD of S&P Global Market Intelligence, US issuances topped $19.2 billion in August, a monthly record in data from a decade ago.

Analysts said the record was a generally slow month for the market, a sign managers are pushing to close deals before the end of LIBOR. Some CLO documents lack language covering changes to the new interest-rate benchmark, which could cause disruption as the new year approaches.

Instead of waiting to see how the transition pans out, CLO managers are taking advantage of recent investor demand and closing deals if possible, said Joe Lynch, global head of non-investment grade credit at Neuberger Berman. Said, which manages and invests the CLO.

“Most managers plan to issue another CLO before the end of the year and will probably work out a deal in the near term to avoid any potential disruption that could come from the LIBOR transition,” he said.

A strong US economic recovery and support from the Federal Reserve have improved the prospects of many low-rated companies borrowing through the leveraged debt market, which is often used by private-equity firms to finance acquisitions. This marks a reversal in 2020 following concerns about large-scale defaults following the outbreak of the pandemic and a fall in risky debt prices.

The previous 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 fuel investor demand for CLOs, the largest buyers of leveraged loans. As of August, new CLO sales in the US have exceeded $111 billion in 2021, according to LCD — on pace to surpass 2018’s record of nearly $129 billion.

Analysts at Bank of America said in an August note that many expect new CLO sales to pick up in September as issuers try to close deals before the transition. 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.

Analysts said a wave of CLO refinancing this year allowed some managers to include fallback language transfers to SOFRs in their documents. But for other deals, CLO managers and investors must negotiate that change, which can create conflict if there are different rate preferences.

The disruption in transition could drive up the additional yield, or spread, that investors are seeking to hold triple-A rated CLO loans during the fourth quarter of this year, depending on how quickly the debt market moves. Change happens and new CLO deals and how investors position themselves. , Citi analysts said in a June note.

SOFR is based on transaction costs in the market for overnight repurchase agreements, where large banks and hedge funds borrow or lend to each other using US Treasuries as collateral. Unlike LIBOR, which rises during periods of market stress, it does not adjust for changes in credit.

According to BofA, during last year’s spring sales, the difference between the three-month LIBOR and SOFR increased by 1.4 percentage points. This means that CLO debtors received a higher rate of return than if their bonds were linked to the SOFR.

“It is particularly important [triple-A CLO bondholders] where reference rate [makes] a significant part of the interest rate,” analysts at the bank said in a note.

Moving away from LIBOR also means that some CLO securities may have a different benchmark rate than the loans in their collateral pool. This makes it more difficult for investors to protect their holdings against fluctuations in interest rates and underlying loan prices.

“We anticipate that the market will take some time to digest” [new] “Released when the SOFR changes in the new year,” said Serhan Sekman, head of CLO investment at Napier Park Global Capital.

This story has been published without modification to the text from a wire agency feed