'Nonchalant' CLO Market Faces Hedging Risks in Libor Transition

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The booming collateralized loan obligation market faces a chaotic end to 2021, when the benchmark London interbank offered rate is retired for new loan contracts.

At issue is how to hedge the risk to investors in CLOs, which are based on Libor, when their collateral pools are made up of leveraged loans based on a completely different benchmark. New loans may switch to an alternative such as the recommended Secured Overnight Financing Rate, which measures the cost of borrowing using Treasury securities as collateral.

Some investors are worried that this mismatch will add a new layer of so-called basis risk -- the possibility of losses or gains due to imperfect hedging -- to an already complex product. Prices in the $820 billion U.S. CLO market could become more volatile, and there’s a chance of reduced returns to CLO equity holders, who hold the riskiest slice of the deal and are the last to be paid, but can earn the highest potential payments.

“The CLO market has so far been incredibly nonchalant about the upcoming benchmark transition,” Laila Kollmorgen, a CLO portfolio manager at PineBridge Investments, said in an interview. “We’re not seeing any attention being paid to it at all, even by the investors who may be most impacted - the equity investors. Either they’re so sophisticated that they’re already aware, or perhaps they know and they dismissed it -- or perhaps some investors don’t know and don’t know to ask.”

CLOs already suffer from some basis risk with leveraged loans -- most leveraged loans are pegged to one-month Libor, while CLOs are priced off three-month Libor -- and the transition away from Libor exacerbates it.

Libor is being eliminated out of concern it can be manipulated, and as underlying trading informing the rate has dried up. Regulators told U.S. banks to end Libor origination “as soon as practicable” and no later than December 31 of this year. The rate will be retired for good from all transactions by June 2023 at the latest.

While some CLOs have so-called fallback language in their documentation governing the cessation of Libor, some still don’t. Investors say they expect a period of confusion over basis risk in early 2022 that could last several months.

“We have been internally trying to identify transactions in which we have risk,” PineBridge’s Kollmorgen said. “While we don’t expect this to cause a huge disruption in the CLO market, it’s really more about being informed, which is important.”

Volatility Ahead

The expected turbulence will cap what is projected to be a record-setting year of sales of CLOs, with Bank of America Corp. forecasting $360 billion of U.S. CLO issuance. That includes $140 billion for new issuance and $220 billion for refinancings and resets of older deals.

JPMorgan Chase & Co. published a research paper on Thursday that said the global CLO market has now reached $1 trillion as “investors are looking for supply and spread in highly-rated instruments.”

'Nonchalant' CLO Market Faces Hedging Risks in Libor Transition

The phase-out of Libor on new leveraged loans will pressure spreads on CLO AAA tranches in the fourth quarter, said Maggie Wang, a CLO analyst at Citigroup. Moreover, the basis risk can lead to 30 basis points of fluctuation in quarterly CLO equity cash flows, which may resolve over time but still pose interim risk.

“The ultimate impact on CLO spreads will largely depend on how quickly the loan market transitions and how CLO investors and transactions position themselves,” Wang said.

In a bit of good news for investors, this year’s record CLO refinancing wave has allowed managers to amend documents on many existing deals to include the latest fallback language by the Alternative Reference Rates Committee, a group put together by the Federal Reserve and the New York Fed to help with the transition.

Still, if a CLO’s documents are unclear on the matter, managers may have to get consent from debtholders, who hold the controlling class of the transaction. Switching the benchmark can become more complicated in this instance, since controlling classholders will do what benefits them most, and may be different from what the CLO manager wants, according to Deutsche Bank analysts.

The general governing rule in documentation is that if 50% or more of a CLO’s collateral is based off a particular benchmark, then a CLO manager can move the CLO bonds to that new benchmark as well.

“New CLOs coming to market at the end of 2021 and in 2022 will be some mixture between Libor and SOFR,” PineBridge’s Kollmorgen said. “We’ll just have to see exactly how mixed they are. It all depends on how volatile that basis risk is going to be.”

U.S.

Investors are backtracking on reflation bets, with the bond rally extending as central banks signal continued support and stocks falling as Covid-19 variants threatened reopening prospects.

  • Investors in the $1 trillion private credit market are allocating their money into a smaller number of funds as they consolidate commitments, according to a report by industry research firm Preqin Ltd
  • The market for collateralized loan obligations crossed the $1 trillion threshold globally, a symbolic milestone that signals the maturing of an asset class once considered an esoteric corner of the credit world
  • California State University is bringing its largest taxable bond offering ever to the municipal bond market on Thursday as part of a deal to refund debt and finance the construction and renovation of campus buildings
    • For deal updates, click here for the New Issue Monitor
    • For more, click here for the Credit Daybook Americas

Europe

  • Credit default swap spreads are widening; default insurance in European high-yield corporates rose as much as 11.6 basis points, the most since March
  • The primary market is busy again with at least 12 live deals today, coming on the heels of a 19-tranche session on Wednesday
  • Jaguar Land Rover opened books on a EUR/USD offering (see story)
  • SSAs are busy; France’s ALS and IDA are out with EUR notes, while the World Bank is offering bonds in sterling; Lithuania is also offering a euro 30Y benchmark
  • In HY space, Pizza Express is marketing GBP335m of 5NC2 notes at 7% area
  • A global hunt for yield that’s pushing investors into lower-rated debt remains on track with buyers seeking the most attractive deals amid concern they’ll miss out, Nick Darrant, Citigroup’s co-head of EMEA debt capital markets syndicate, said in a virtual round table with journalists
  • Investors are divided over whether ‘greeniums’, or premiums for green or sustainability-linked bonds (SLBs), are justified, according to a survey of more than 170 credit investors by the European Leveraged Finance Association

Asia

  • The pace of issuance in Asia’s primary dollar-bond market slowed Thursday, after a busy start to the week that saw at least a dozen borrowers raise funds

    • Chinese high-yield dollar bonds rebounded as much as 2 cents on the dollar Thursday morning, according to credit traders, after two weeks of declines

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