January 27, 2022 - The shift to SOFR has been as boring as we had hoped (and had worked toward!). According to LCD, there has been more than $60 billion of SOFR leveraged loans hitting market in January, accounting for more than 95% of volume. While SOFR loan origination was expected, commentators had expected a slower start in SOFR CLO formation. And though CLO volumes lag 2021 levels, there still has been nearly $6 billion in new, refinanced or reset SOFR CLOs (see slide 3 here). We discussed these dynamics in an S&P/LCD Webcast this week, examine them below and will drill deeper into them in an LSTA/DealCatalyst webcast in the coming weeks.
The CLO pace is anticipated to accelerate. LFI writes that the primary CLO market might approach the heights seen in 2021; the outstanding pipeline stands at 139 deals (68 new issues and 71 repricings). In addition, we might see a number of existing CLOs fall back from LIBOR to SOFR sooner than expected. Why? If investor demand for loans remains strong, this may lead to more companies opportunistically refinancing or repricing into SOFR, BofA noted. Meanwhile, many CLOs have an “Asset Replacement Trigger” that states that once the majority of loans in a CLO’s portfolio or majority of new CLOs are priced off of SOFR, then the CLO may opt in to SOFR early.
Now that we’ve established that SOFR loans and CLOs are buyable, it’s a matter of working out the cost. While price discovery has been ongoing, as Refinitiv has written, the concept is relatively straightforward in the CLO market: most SOFR CLOs are pricing with no credit spread adjustment (“CSA”) and a margin 15-20 bps higher than the equivalent LIBOR margin.
This process is a bit more complicated in the loan space, albeit for entirely rational reasons. While the loan market undoubtedly will adapt to pricing loans cleanly off SOFR, some parties are looking to keep SOFR economics transparent and similar to LIBOR economics in these early days of transition.
The first SOFR loan pricing approach uses CSAs. Because SOFR is a risk-free rate and LIBOR is a credit-sensitive rate, the CME Term SOFR Curve is both lower and flatter than LIBOR (Slide 4). A flat CSA of, say, 10 bps for all interest rate tenors shifts up the original Term SOFR curve (green line), but the curve remains fairly flat (red line). A CSA curve of 10 bps for 1M, 15 bps for 3M and 25 bps for 6M both shifts the SOFR curve up and rotates it, creating a higher, steeper – and more LIBOR-like – curve (yellow line). While the CSA creates clarity around the spread adjustment, advocates also note that it may be important for some forms of pre-ARRC Amendment Fallback language, which loosely direct parties to look to any evolving or then-prevailing market convention; if there is no CSA in the primary market, these lenders note, then loans that fall back from LIBOR to SOFR using this amendment approach might not adjust the LIBOR margin either.
That said, lenders note that CSAs will eventually disappear, and some deals already are coming to market with either a CSA theoretically embedded in the margin (though one might expect to see more loans with non-standard margins were this the case!) or simply pricing SOFR loans at the same margin as a LIBOR loan (which is, we’d note, an economic transfer from lender to borrower). We will discuss these dynamics – and many more – in the LSTA/DealCatalyst Webcast coming in a few weeks.