CLO funds push for fallback benchmarks before Libor ends

By Kristen Haunss

NEW YORK, Nov 2 (LPC) - Some US credit investors are pushing to use alternative benchmarks in the documents of new Collateralized Loan Obligation (CLO) funds before official replacements to Libor are identified ahead of its demise in 2021.

The US market is set to adopt the Secured Overnight Financing Rate (SOFR) as an alternative to Libor, the benchmark that is used globally to set the interest payment on over US$350trn of assets.

Andrew Bailey, the chief executive officer of the UK’s Financial Conduct Authority (FCA), said in 2017 that there were insufficient transactions underpinning Libor, which sets the rate on loans from corporate borrowings to mortgage payments.

Some CLO funds, however, are already considering alternatives. Wells Fargo and Prudential are among firms that are suggesting an eventual fallback to the Prime Rate, which is typically more expensive than Libor.

CLOs are proposing additional benchmarks as SOFR is an overnight rate and currently lacks a term rate for different maturities; most CLO payments are pegged to three-month Libor.

The US$567bn US CLO market, the largest buyer of US leveraged loans, initially reworked documents after the FCA’s statement to include language that would require debt investors to approve a benchmark change.

The documents now say that the new benchmark will be recognized as the industry standard by the Loan Syndications and Trading Association or the Alternative Reference Rates Committee (ARRC), a group set up in 2014 by the Federal Reserve (Fed) and the Federal Reserve Bank of New York to identify best practices for alternative rates.

The ARRC has recommended shifting to SOFR, which began trading earlier this year and now has about US$800bn of trades a day.

ARRC is asking for feedback by November 8 on fallback contract alternatives for syndicated loans and floating-rating notes to find the best way to move existing contracts to the new benchmark if Libor is no longer viable.

LIBOR MODIFIERS

Investors that purchase the most senior and largest portion of the fund, the Triple A tranches, now want a bigger say in selecting future benchmarks.

As SOFR is currently an overnight rate with no term rates, some CLO investors are concerned that proposals, such as picking the last Libor rate or an average that would not be reset, would effectively turn a floating rate asset into a fixed instrument, and investors would not be adequately compensated.

CLOs pay most debt holders a set rate over Libor, which rises as interest rates increase, which makes the funds attractive in a rising interest rate environment. The Fed has hiked rates eight times in the last three years.

“Some investors are requesting modifiers be added to the new benchmark in the Libor replacement language of CLO documents that take into account the historical performance and movement of Libor,” said Lawrence Berkovich, a partner in the structured finance practice at law firm Allen & Overy.

Some investors are also asking that the rate eventually revert to Prime if no benchmark is acknowledged as the industry standard, or a vote on a proposed alternative from the CLO manager does not pass, sources said.

The threat of a move to pricier Prime may force investors in the most junior portion of the fund and managers to call or rework a CLO to set terms at market rates, those sources said.

Since the FCA’s announcement last year “we have been focused on Libor replacement language across structured products,” said John Vibert, head of structured products at PGIM Fixed Income.

“It is important in securitizations where the expected maturity is well beyond the date the FCA specified it will no longer be compelling submissions..and there is not a natural mechanism to put a fix in place,” he said.

A Wells Fargo spokesperson declined to comment.

ARRC is expected to seek a similar consultation for securitizations as with loans and FRNs, the group said in a September news release.

“Libor is highly likely to be unavailable after December 31, 2021 and these are longer term assets, so investors should be concerned and looking for straight-forward processes, otherwise it will be a negotiation at the time, which will be harder,” said Adam Schneider, a partner at consulting firm Oliver Wyman.

“From the standpoint of buying into a CLO, where you know the Libor problem is coming, having a straightforward process would be great.” (Reporting by Kristen Haunss Editing by Tessa Walsh and Michelle Sierra)