By Kristen Haunss
NEW YORK, Sept 13 (LPC) - A debate has been brewing in the US Collateralized Loan Obligation (CLO) market as some investors and managers push back on regulatory recommendations for how best to transition from a benchmark trillions of dollars of investments rely on.
Wells Fargo and PGIM are pushing managers to adopt language recommended by a Federal Reserve (Fed)-backed group into new CLO documents that lays out steps to replace Libor as a requirement for their investment in the largest and most senior portion of the funds, according to five sources familiar with the discussions.
Some junior investors and managers have balked at the requirement and sought out other Triple A buyers that do not require the provision, the sources said. There is a concern that this is a ‘cart before the horse’ request, with some CLO participants frustrated that the funds are being pushed to transition before the loan market does.
Tensions have been rising since Andrew Bailey, chief executive officer of the UK’s Financial Conduct Authority, in 2017 said Libor needed to be phased out by the end of 2021. The announcement has thrown documents for both the US$1.2trn US leveraged loan market and the US$641bn US CLO market into question, with companies and managers jockeying to ensure their positions are not altered by a change in rate.
The loan market has been slow to adapt the recommendation of the Secured Overnight Financing Rate (SOFR), a broad measure of the cost of borrowing cash overnight collateralized by US Treasury securities, because there are no SOFR term options like one-month and three-month Libor, which companies peg their interest payments to.
“Many bankers believe it is less risky to make a LIBOR loan than a SOFR loan, because Libor has good characteristics, is better known, is more easily hedged, and term SOFR is still in the future,” said Adam Schneider, a partner at Oliver Wyman co-leading the firm’s Libor practice and chair of the Fed’s Alternative Reference Rates Committee (ARRC) new operations working group. “That needs to change. Term SOFR is likely to be created, but waiting is a mistake. Banks need to build out a full suite of non-Libor products based on overnight SOFR now.”
ARRC in May released recommended securitization fallback language that predetermines the transition away from Libor, known as a ‘hardwired approach.’
When a trigger event has been determined, ARRC recommends a move to a forward-looking term SOFR rate plus a spread adjustment. If that option does not exist, then the benchmark would move to compounded SOFR plus a spread adjustment. It would then continue down a pre-determined set of alternatives until there is a viable option.
“Our goal on fallbacks is to hear what works best in the market and ensure borrowers and lenders end up in a fair place,” Tom Wipf, ARRC chair and vice chairman of institutional securities at Morgan Stanley, said in an interview. “We always tried to look at it from a risk management perspective. Currently continuing to use Libor without any of these tools are adding to risk we already have.”
Wells Fargo supported a hardwired approach in a November 26 letter to ARRC about loan fallback language. The bank, however, noted in a separate February 5 letter that the consultation does not address what would happen if the underlying assets transition to a replacement not contemplated by the proposed waterfall for securitization liabilities, which could magnify the basis risk and cash-flow mismatches.
If there is no term SOFR or compounded SOFR available, loans flip to an amendment approach, which allows an agreement to be reworked to replace Libor with an alternative benchmark, while CLOs continue down the predetermined replacement rate waterfall.
If loans and the funds are pegged to different rates, CLO equity holders, who own the riskiest portion of the fund and receive distributions from the interest leftover after all debtholders are paid, may receive lower payments, two of the sources said. To adjust the rate would likely require a 100% unanimous vote of CLO investors, which would be difficult to achieve.
“Deals that have uncertainty over the base rate that don’t have ARRC (language) will suffer from some liquidity issues as investors need to understand the nuances of what a manager may or may not do because of the opaqueness of not having ARRC language,” said Edwin Wilches, a portfolio manager at PGIM where he invests in the debt of CLOs. “Not having ARRC (language), a manager can do what they think they should do, and that can cause some issues and concerns about what the rate is going to be.”
He does not agree with the assertion that managers or investors are choosing to work with other Triple A investors instead of PGIM due to ARRC language.
“Everyone pushed back (on the ARRC language) in the beginning, but the winds have changed since the start of September,” Wilches said. “Managers are starting to feel better about the issue. I don’t think it will have a 100% adoption rate any time soon, but I do strongly believe we will get there as a market.”
A Wells Fargo spokesperson declined to comment.
As the US CLO market begins to ramp up after the US summer holiday, it is unclear if or how many additional Triple A investors will adopt the posture of Wells Fargo and PGIM. But participants agree that as it gets closer to 2021, CLO documents will need to adapt.
“We have moved into a phase where people are thinking about how do we deal with the permanent cessation of Libor,” Wipf said. “These discussions are technical, but probably a good place to get into the weeds when we have a little more than two years on the clock” until Libor goes away. (Reporting by Kristen Haunss. Editing by Michelle Sierra.)