June 23, 2020 - How are thoughtful investors preparing for LIBOR cessation? Last week, LSTA EVP Meredith Coffey caught up in an IMN panel with KKR’s Tal Reback (who represented the loan/CLO manager perspective) and Edwin Wilches (who represented the CLO investor point of view) to discuss their preparations.
The IMN panelists reflagged the end of LIBOR (we still have to assume it’s around December 2021), identified different SOFR options (and when they will be workable), reviewed challenges (and signs of progress) from a CLO manager and investor point of view, and recapped the ARRC’s best practice recommendations for loans and CLOs.
As we have discussed (possibly ad nauseum), SOFR itself is an overnight rate, but one would not lock in one day’s SOFR for a 30- or 90-day interest period. Instead, there are four potential “tenored” SOFRs. SOFR Compounded in Advance and Forward Looking Term SOFR are operationally similar to LIBOR because the rate is known in advance of the interest period and thus counterparties can lock in one rate for the entire period (and not change conventions or systems). But these “known in advance” SOFRs have their challenges. SOFR Compounded in Advance can be stale and can create asset-liability management issues. Meanwhile, Forward Looking Term SOFR does not yet exist as a reference rate and therefore we shouldn’t put all our eggs in its still-to-be-developed basket.
Daily Simple SOFR and SOFR Compounded in Arrears are less like LIBOR inasmuch as you don’t know the rate at the beginning of the period, but instead pull the rate (and compound it for SOFR Compounded in Arrears) during the life of the loan. (As slide 6 demonstrates, Simple Daily SOFR and SOFR Compounded in Arrears are economically quite similar, but SOFR Compounded in Arrears is operationally more complex.)
Timing-wise, Daily Simple SOFR and SOFR Compounded in Advance could be operationalized in the near term, SOFR Compounded in Arrears likely could be operationalized in late 2020/early 2021, and Forward Looking Term SOFR must await the development of an official term curve.
So, in light of these uncertainties, what are thought leading managers and investors doing? KKR’s Tal Reback and PGIM’s Edwin Wilches joined us to discuss.
On the loan management side, one should remember that repapering and amending a wide swath of loan documents is challenging in the best of times – and it will only be harder to do en masse at LIBOR cessation. This reason alone makes hardwired loan fallbacks more attractive. In addition, the operational challenges of SOFR Compounded in Arrears should not be underestimated. But on the positive side, there is much more awareness that the end of LIBOR is coming, a lot of work on operationalization has been completed, and headwinds are abating (and tailwinds are strengthening).
On the CLO investment side, while CLOs adopted hardwired fallbacks before loans, inconsistent fallback language may lead to issues. Pre-2018 CLOs generally have inadequate fallback language and CLO notes may end up flipping to “last quoted LIBOR”, thus converting into a fixed rate instrument. 2018 CLOs generally used amendment fallbacks, so difficult decisions must take place at LIBOR cessation. Starting mid-2019, most CLOs began to use hardwired fallbacks and thus have a clearer path to transition. This is becoming significant in the secondary: Market sources have noted that CLOs with “bad” fallback language are increasing hard to trade in bulk than CLOs with better language.