February 8, 2022 - We are in the fifth week of the “Post LIBOR” new issue world for loans and CLOs. To mark the occasion, the LSTA and DealCatalyst hosted an on-demand webcast titled, “It’s a SOFR World! How are CLOs and Loans Faring?” The webcast features LIBOR transition thought leaders Tal Reback of KKR and Edwin Wilches of PGIM. We discuss key takeaways below and offer access to the webcast itself here.
First, we debunked the myth – or maybe leaned into the reality – that LIBOR transition was “just like Y2K”. In fact, it was similar inasmuch as there were thousands of LIBOR gnomes diligently laboring in the background in ways that weren’t apparent to market participants. The fact that we are sitting here a month into SOFR and no explosions have been sighted is testament to hard work – and maybe a little luck.
We drilled into the critical preconditions for the adoption of SOFR. The first was capitulation that LIBOR really was going away. The second precondition was the emergence and ultimate recommendation of Term SOFR. Panelists recounted white knuckling – and bare knuckling! – in late spring when it wasn’t clear that the ARRC would recommend Term SOFR and whether BSBY or Term SOFR was going to be the main LIBOR replacement for the leveraged loan market.
We discussed pricing metrics in loans and CLOs. In loans, the debate is largely around whether or not to “CSA”, e.g., offer a distinct Credit Spread Adjustment. Slide 4 of the powerpoint demonstrates the mechanics of a “flat” CSA, which shifts the SOFR curve up vs a “CSA Curve”, which both shifts up and steepens the SOFR curve. As Slide 5 shows, while the bulk of loans are using a CSA in some form, 30% of January SOFR loans priced “SOFR flat”, e.g., without a CSA. The panelists argued that a CSA is not ultimately necessary in loans and not currently used in CLOs (Slide 7); the argument is that credit professionals price credit risk and a CSA simply obscures the process. The counter argument is that a CSA is a temporary stage to familiarize market participants as they transition from LIBOR to SOFR pricing and also that it can help ensure that loans falling back using older, pre-ARRC amendment fallback language include CSAs when they transition to LIBOR.
We discussed SOFR CLO price discovery and activity. Panelists noted that the pricing process was pure capital markets price discovery. The market found a clearing price – in the 130s over SOFR for AAAs, about 15 bps wider than LIBOR – as an anchor point for benchmark issuers and everyone is pricing around it. And now we’re off to the races! There was $8 billion of SOFR CLO action in January. And, as of early February, there have been more than a dozen CLO deals sighted vs. 19 in all of January.
We considered what we’re going to see with the legacy book of loans. Panelists felt that there would be an acceleration of transition activity in 2022. Why? First, as CLOs start printing on SOFR, demand for SOFR loan assets will increase. Conversely, there are tail risks in staying in LIBOR, including declining liquidity. In turn, the next few quarters will be very busy for loan refinancings or opt-ins. A hardwired loan borrower might want to refinance early, rather than falling back using the ARRC’s 11.4/26.2/42.8 bps hardwired spread adjustments. But a borrower with an amendment fallback might want to use an early opt-in trigger, locking in the lower spread adjustment used on today’s new issue loans.
We also pondered CLO fallback activity. While language varies, CLOs often have two types of early opt-in fallback triggers: 1) When 50% of the loan assets are priced off SOFR and/or 2) when 50% of the new CLOs in the last three months are priced off SOFR. (We’ll clear that second trigger in April.) Like loans, some older CLOs also didn’t require a spread adjustment when transitioning and a number also leave discretion of when or how to transition in the hands of the manager. Managers often do not like having said discretion as either the debt or the equity will be unhappy with the decision.
We talked about how we never want to through such a transition again…which means having good SOFR fallback language. On the loan side, panelists are pushing for prescriptive language. (Note that Covenant Review is seeing about 85% of new SOFR loans using hardwired fallbacks, starting with Daily Simple SOFR.) On the CLO side, a number of investors still are looking for a rate recommended by the LSTA. (Editorial aside: Please don’t do this. The LSTA cannot and will not recommend a rate.) In addition, there is debate around if Term SOFR is temporarily discontinued and a CLO falls “down” the fallback to a daily rate like Daily Simple SOFR or Daily Compounded SOFR, whether it should “climb” back up to Term SOFR if it is reinstated. Panelists noted that there’s good argument for this “climb the waterfall” language, particularly as a daily rate is challenging in a CLO context.
And finally, we wrapped up with some key takeaways. First, on new deals, don’t use LIBOR if you can help it. While there might be shades of gray – direct lending, accordions – LIBOR is dying and there are tail risks to remaining in it. Second, on existing deals (and, for that matter, new deals), know your fallback language. There was a lot of heartache before Term SOFR was endorsed; Daily Simple SOFR and Daily Compounded SOFR are challenging for loan trustees, custodians or products that calculate a daily NAV.