June 27, 2019 - There are $1.2 trillion of institutional loans outstanding, and nearly $700 billion are housed in CLOs. When the reference rate of loans and CLOs are not aligned, basis risk emerges. This was notable – and painful for equity – in 2018 when the 1-month/3-month LIBOR curve steepened to 50 bps and corporate borrowers switched to one-month LIBOR while CLO liabilities continued to reference three-month LIBOR. But basis risk doesn’t stop there; it is an issue to be considered with LIBOR fallbacks as well. If loans fall back at a different time from CLOs (which they may well do) or if they use a different SOFR variant from CLOs (like Forward-Looking Term SOFR for loans vs. SOFR Compounded in Arrears for CLO notes), basis risk could emerge. However, on a potential “fix-it” note, if both loans and CLOs ultimately use SOFR Compounded in Arrears, one-month/three-month basis risk will be minimized because a compounded rate does not increase dramatically between a one-month and three-month term. We deconstruct potential basis risk issues below.
There are two major components of fallback language: 1) the trigger event that “triggers” the transition from LIBOR to a replacement rate and 2) the selection of a replacement rate (plus spread adjustment in most cases).
The loan hardwired fallbacks and securitization fallbacks have both these components and the ARRC attempted to align them as much as possible. That said, there are some inevitable differences. (Note that we are only addressing hardwired fallbacks; because rates are not predetermined in loans’ “amendment approach” fallback, it is not possible to determine whether it would be aligned with CLO liabilities.)
Triggers: Loans and CLOs have the same “basic” triggers, but each add an additional trigger that allows for earlier fallbacks. Both loans and CLOs have triggers i) if the LIBOR administrator or ii) the relevant regulator announces that LIBOR has or will cease. Likewise, both loans and CLOs have a trigger if the relevant regulator states that LIBOR is no longer representative. If one of these three events occurs, then loans and CLOs trigger at the same time.
However, both loans and CLOs want the opportunity to shift to a replacement rate well before the end of LIBOR. For this reason, loans also have an “Early Opt-In” trigger, whereby if a certain number of loans are being issued or amended to shift to term SOFR (plus a spread), then the loan can be more easily amended to transition to SOFR. This permits lenders and borrowers to reduce their LIBOR inventory.
Meanwhile, securitizations (including CLOs) do not want to have their liabilities tied to LIBOR if many of their assets are tied to SOFR. Thus, securitization fallback language also includes a trigger if more than 50% of a securitization’s assets have shifted to a replacement rate.
Waterfalls: Both hardwired loan and securitization fallback language have a waterfall of replacement rates and spread adjustments. The first two levels of the waterfall are the same. After those two levels, the loan replacement rate is chosen via the amendment approach, while CLOs continue to work down their waterfall.
The first waterfall level for both loans and CLOs is Forward Looking Term SOFR plus a spread adjustment. If Forward Looking Term SOFR does not exist, the second level is Compounded SOFR plus a spread adjustment. The preferred spread adjustment would be the one recommended by Relevant Governmental Body (ARRC or Fed); if that doesn’t exist, it would be the spread adjustment recommended by ISDA. If that doesn’t exist, the securitization language also has a spread adjustment selected by the “Designated Transaction Representative” (e.g., someone designated to do this dirty work).
As discussed above, if neither term SOFR nor compounded SOFR are available, then loans flip to the amendment approach, while CLOs continue down the replacement rate waterfall. The third level of the securitization waterfall is the rate of interest selected by the Relevant Governmental Body plus a spread adjustment. If that doesn’t exist, the fourth level is the ISDA Fallback Rate plus a spread adjustment. If that doesn’t exist, the final stage is that the Designated Transaction Representative selects the rate plus spread adjustment. While most hardwired adherents believe we will not go past the first two stages of the waterfall, if we do, CLOs and loans may diverge.Mitigating Basis Risk: If loans begin to switch to SOFR first, this will introduce some basis risk into CLOs. However, if the market gets the spread adjustment right, the basis risk should be minimized. Forward Looking Term SOFR also could have some basis risk if borrowers select one-month SOFR and CLO liabilities are on three-month SOFR. Interestingly, if both markets move to SOFR Compounded in Arrears, the basis risk problem should be nearly eliminated. Because three-month Compounded SOFR is just a longer version of one-month Compounded SOFR, their differential should not be nearly as large as the one-month/three-month LIBOR basis can be.