May 26, 2021 - by Meredith Coffey. It’s possible – indeed, inevitable – that loans will exist in a multi-rate world after LIBOR originations cease in late 2021. At a minimum, there will be legacy LIBOR loans and at least one type (and maybe more) of replacement rate loans outstanding. So, what does this means for CLOs? That was the topic moderated by LSTA EVP Meredith Coffey and tackled by Edwin Wilches (PGIM), Dan Wohlberg (Eagle Point), Sagi Tamir (Mayer Brown) and Prakash Mahtani (PWC) at Wednesday’s IMN CLO Conference. We discuss key takeaways below – and direct you to the slide deck, which contains helpful reference materials.
First, we’d flag that US LIBOR transition will proceed on a bifurcated timeline: No new LIBOR origination after year-end 2021, but legacy USD loans and CLOs do not need to transition to a replacement rate until after June 30, 2023.
Next, we’d note that there still are multiple replacement rates in play in the US syndicated loan market, including Credit Sensitive Rates (CSRs), Forward Looking Term SOFR, Daily Simple and Daily Compounded SOFR. Slide 4 compares their characteristics to LIBOR. Importantly, many US loan market participants want to know their interest rate “in advance” of the interest period; practically speaking, this pushes many of them toward Term SOFR or CSRs. In addition, Slide 5 shows that, economically, CSRs look more like LIBOR, and both CSR and LIBOR term curves are higher and steeper than SOFR curves (which are all correlated to each other, but not terribly correlated to LIBOR).
The rate alternatives – and the bifurcated timeline – have implications for CLOs. To discuss, we broke CLOs into three cohorts: i) Legacy (pre-2022) CLOs before their liabilities transition to a replacement rate; ii) legacy CLOs after their liabilities transition; and iii) new (post-2021) CLOs issued on a replacement rate.
As Slide 6 shows, legacy CLOs typically will originally have both their liabilities and many of their assets based on LIBOR; thus, initially, there is no LIBOR-replacement rate basis. But as we move into 2022, new loans will be originated on a replacement rate and thus more basis may emerge between assets and liabilities. Still, panelists felt that such basis could be managed.
Next, the liabilities of these legacy CLOs eventually will transition to a replacement rate. Slide 7 shows the many (many!) ways this could occur. Some CLOs have an “Asset Replacement Trigger”, which can both influence the timing of transition, as well as the rate to which CLO liabilities fall back. While there are many nuances, what is clear is that both the timing of fallbacks as well as the rate to which CLOs fall back – SOFR variant? CSR variant? – may be highly variable.
Finally, there will be new CLOs. Slide 8 notes that there are a number of scenarios for new CLOs that are issued after 2021. First, if the loan market adopts Term SOFR, it’s reasonably likely that CLO liabilities would adopt a SOFR variant as well and alignment generally continues. Second, if the loan market adopts a CSRand CLO liabilities reference SOFR, then there will be more basis in the CLO (but, again, the equity should be able to manage basis). Finally, if the loan market adopts a CSR and the CLO liabilities adopt CSRs, then basis is again limited, but CLO liabilities might be using rates dissimilar to other securitized products.
To bottom line it, a panelist concluded that it will be an “interesting” – he may have used a different word – few years, but we’ll all get through it and be just fine in the end.