CLO Transition to SOFR Gets Riskier On Volatility From Omicron

(Bloomberg) -- The surge in Covid cases linked to the omicron variant adds another complication for managers of existing U.S. collateralized loan obligations that have some discretion over when they start using SOFR as a benchmark for their liabilities.

A potential increase in financial market volatility as the variant makes its way through the U.S. and other corners of the world could widen the difference between the London interbank offered rate and its preferred replacement, the Secured Overnight Financing Rate, according to Bank of America Corp. strategists. That in turn could change funding costs for asset management firms that funded their loan portfolios by selling CLOs.

Investment firms that manage CLOs issued this year or earlier generally can change the benchmarks of their liabilities when at least 50% of the loans they invest in are tied to the new benchmark, although they will have to adopt the new benchmark in mid 2023. That gives the money managers some discretion as to when they switch over, because they can decide how many loans tied to SOFR to buy. If switching will make funding much more expensive, firms will probably be slower to change, or they may choose to refinance the deal earlier than anticipated.

That’s because they believe a widely recommended credit spread adjustment of 26 basis points, for three-month rates -- a type of compensation to investors due to the historical price differential between the benchmarks -- was too high compared with where market spreads will be.

But in an omicron twist, if the basis between Libor and SOFR continues to widen due to the virus spread, or central bank tapering of pandemic-era support, 26 basis points may eventually be right on target. That could give fund managers an incentive to switch sooner than they might otherwise. This amounts to another factor for investment firms to weigh as they consider timing.

Read more: Libor is dead, almost! What it was, what comes next: QuickTake

Increased volatility due to the omicron variant “might have a widening bias between Libor/SOFR basis and spreads in general,” BofA CLO analysts led by Pratik Gupta said in a Dec. 17 report.

Wrong Direction

Just two CLOs late this year -- one new-issue transaction and another reset of an earlier deal -- each had one tranche tied to SOFR, while the rest of the tranches were still priced off of Libor. Those deals had an implied spread adjustment of only 15 to 20 basis points, BofA said, still less than the 26 basis point adjustment recommended by the Alternative Reference Rate Committee, a group backed the Federal Reserve.

Based on where the three-year Libor/SOFR swap curve is currently trading at, near-term CLO deals that have liabilities tied to SOFR will have an implicit spread adjustment of only 20 to 22 basis points. If those adjustments remained static, the 26 basis point suggestion would still be too high.  

But things are going in the wrong direction. 

“The Libor-SOFR basis has seen significant widening over the past few months, indicating higher spread adjustment going forward,” the strategists said.

How it Works

When CLOs drop Libor, they are contractually obliged to pay investors extra interest to compensate for the fact that the old benchmark rates tend to be higher than the new ones. It’s tricky to figure out how big that extra interest, known as a credit spread adjustment, should be. 

For example, the ARRC recommended that existing assets tied to three-month Libor, such as CLOs and some loans, use an adjustment of about 0.26 percentage point, or 26 basis points when switching to SOFR. That’s based on a five-year average difference between the new and old rates. But some recent loan deals tied to SOFR priced with three-month adjustments at around 15 basis points, because whatever the difference was historically, the old and new rates are much closer to each other now.

Most CLOs sold this year are set up to automatically use the ARRC adjustment, which may be too high, according to some money managers. That could potentially boost the funding costs for CLOs, cutting into the income that the riskiest securities, known as the equity, can receive.   

The relatively high interest rates that CLOs will have to pay stem from the procedures for switching benchmarks on the securities. The CLOs that are issued now generally have to move to SOFR when at least half the loans in their portfolios are tied to the new rate. Beginning in 2022, new deals are required to stop using Libor, though older transactions are allowed to use it till the middle of 2023.  

“Some deals would transition to SOFR prior to June 2023 if a majority of loans in the portfolio reference SOFR,” the strategists wrote. “This could be an impetus to higher refinancing/reset volumes if the 26 basis point spread adjustment is deemed higher than market spreads.”

CLOs are unique in their ability to refinance over and over again. Once a CLO is eligible to be called, managers can refinance or reset the securities they issued whenever they wish, to cut their funding costs.

CLO manager purchases of SOFR loans continues in full swing, BofA said, with SOFR-linked loan exposure across 592 CLOs increasing to $1.3 billion.  The exposure in certain CLOs deals has reached between 2% and 4%, they said.

Relative Value: CLOs

• Goldman Sachs Asset Management is overweight AAA-rated CLOs, strategists said in a recent weekly fixed income report
• CLO issuance reached record highs in 2021. GSAM expects robust supply in 2022, though analysts think the total volume will be lower than this year, they said
• GSAM expects to see more issuance of SOFR-linked CLOs given the Libor transition

Quotable

Regarding the return of Japan’s Norinchukin Bank as an investor in the CLO market:  “Detractors thought the CLO market would crumble when Nochu left. But that didn’t happen,” Dan Ko, a portfolio manager at Eagle Point Credit Management, said in an interview. “Their return to the CLO market shows that there continues to be strong demand for AAA CLO debt, which continues to offer some of the best risk-adjusted returns.”

What’s Next

So far, there are no asset-backed securities transactions in the queue for next week.

NOTE: The Structured Finance Weekly won’t be published next week. The column will resume on Jan. 6.

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