‘People Started Panicking’: Loan Investors Just Saw Costly Flaw


It was only a few bungled words in hundreds of pages of legalese. But they could end up costing leveraged-loan investors in the U.S. billions of dollars in interest payments. And it would have been much more had an analyst not spotted the problem.

“People were not paying attention,” said Covenant Review’s Ian Walker, who put a spotlight on the shortcoming two months ago. “Then people started panicking.”

The issue stems from the fact that the London interbank offered rate, or Libor, which helps set the level of interest payments in the $1.2 trillion industry, is going away and being replaced with something else in mid-2023.

After rates plunged to near zero following the 2008 financial crisis, borrowers began inserting language that guaranteed a minimum interest rate to lure investors even when Libor was at rock-bottom levels. Many loans issued since 2017 describe how they’ll transition over to Libor’s replacement but offer little or no boost for that fallback benchmark in a low-rate environment.

That didn’t matter much before the pandemic, since rates had rebounded to more normal levels. But then Covid-19 panic and the Federal Reserve’s response drove rates back down almost to zero. And they may be stuck there a long time, given the Fed’s plan to suppress them for years. That means a loan that currently pays 4% annually could pay as little as 3% once Libor disappears.

Wake-Up Call

Covenant Review drew attention to the problem two months ago. In a report, the credit research firm pointed out that about a fifth of leveraged loans it sampled had this flaw. The fraction was even higher for the newest deals. In January and February, it was about 30% of loans sold to investors.

The reaction to Covenant Review’s warning was immediate. Zero deals in March had this issue with the rate floor, suggesting a revolt among buyers of the debt.

“This impacts the economics,” said Covenant Review’s Walker. “Everyone will push back.”

For many of these deals, the lawyers had attempted to include a floor for the replacement rate. But rather than using the typical figure of up to 1% used with Libor, they effectively set it at zero or something close to it.

The difference in returns for floating-rate loans in a post-Libor world could be material. The one-month dollar version of Libor fell below 0.5% in April 2020 and currently sits near its lows at 0.11% -- but investors get more than that. The Secured Overnight Financing Rate, the leading candidate to replace Libor in the U.S., is even lower: 0.01%.

A $2 billion loan with a 1% Libor floor would deliver about $69 million less in interest payments over five years if it lost the floor when shifting over to SOFR. Extrapolate that across the entire market, and it’s big money. And while new loans may have resolved the issue -- representing a reprieve for investors after seeing their protections erode -- the problem will persist for loans issued before investors awoke two months ago.

Read More: Crisis-Era Libor Protection Stages Comeback in Leveraged Loans

Not everyone is worried. The recent swell of inflation fear in markets could spark a rise in rates, making floors irrelevant when Libor expires in two years.

“A lot can happen between now and then,” said Tom Shandell, chief executive officer of Marble Point Credit Management, the investment adviser of Marble Point Loan Financing Ltd. “Who knows where rates will be at that time?”

©2021 Bloomberg L.P.

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