March 4, 2021 - Today, LSTA EVP Meredith Coffey led an ARRCist keynote panel at IMN’s LIBOR 2021 Conference. The panel began with “50 Ways to Leave Your LIBOR” and ended by comparing LIBOR cessation to Disneyworld’s Space Mountain … and packed a lot of content in-between. We attach the slides here and cover key takeaways below.
First, on slide 5, we discussed key dates for USD LIBOR Cessation: 1) Now (regulators want hardwired fallbacks); 2) Imminently (FCA and IBA will announce exactly how and when LIBOR will end); 3) 6.30.21 (ARRC recommends that LIBOR loan and derivativeorigination should end; 4) 12.31.21 (US banking regulators say that USD LIBOR origination must end); 5) 6.30.23 (USD LIBOR will cease to exist and all remaining legacy products must switch to a replacement rate).
We then focused on LIBOR transition and the loan and CLO market. On slide 7, we discussed the fact that a number of borrowers say that they will likely refinance into a replacement rate prior to LIBOR cessation on 6.30.23. The good news is these SOFR refinancings will reduce the thousands of loans that would otherwise fall back en masse at LIBOR cessation (left chart, slide 10). The bad news is that the “SOFR+spread adjustment” that the ARRC is recommending for contracts that fall back from LIBOR to SOFR is higher than spot LIBOR (right chart, slide 10), and some leveraged borrowers may negotiate a lower spread adjustment to be incorporated in loans’ margins. Net-net, this would lead to lower loan returns when interest rates normalize.
What’s new is that we tackled basis risk hard. Slide 9 demonstrates that 1M-3M LIBOR basis is a serious risk that managers must manage. In contrast, Slide 10 explains why, even in very high interest rate environments, Simple-Compounded SOFR basis is tiny. But LIBOR-SOFR basis is a key risk to consider. Because LIBOR origination must end by 12.31.21, but LIBOR for legacy products does not end until mid-2023, there will be 18 months where an increasing number of CLO loan assets will be based on SOFR and liabilities will not fully match assets. Many CLOs have fallback language that allows the liabilities to flip to the replacement rate once 50% of the assets are on the new rate. Slide 11 shows three scenarios: 1) 49% of assets are on SOFR, and liabilities are on LIBOR; 2) 51% of assets are on SOFR, and liabilities flip to SOFR; and 3) 51% of assets are on SOFR with a reduced spread adjustment and liabilities flip to SOFR with a full spread adjustment. Scenarios two and three could negatively impact CLO equity returns. Importantly, as discussed last week, LIBOR floors – assuming they are portable to the replacement rate – may be critical to managing this basis risk.