Loan investors ask for higher minimum returns as Libor falls

By Kristen Haunss

NEW YORK, Aug 9 (LPC) - Investors are seeking additional protection in volatile credit markets by asking companies to increase guaranteed minimum returns on leveraged loans, as fears grow that falling US interest rates could drag Libor lower, hitting their returns.

Floating-rate loans pay an interest margin plus Libor, but investors’ returns are falling as Libor rates tumble. Three-month Libor has dropped more than 60bp this year to 2.18% on August 8 and the one-month rate is down more than 30bp to 2.2%.

Consulting firm Teneo, WestJet Airlines and urgent care provider CityMD added ‘Libor floors’ of 1% to boost guaranteed minimum returns on their leveraged loans, and protect investors against further drops in Libor as US interest rates fall.

Most recent US loans have been issued with 0% Libor floors to avoid negative interest rates, but investors are seeking more protection in volatile markets and are asking for 1% Libor floors, as work continues to replace the benchmark.

“With markets so volatile, Libor floors look more like a good insurance policy,” said Jennifer Daly, a partner in the finance group at law firm King & Spalding.

The US Central Bank in July cut rates for the first time in more than 10 years, and volatility is rising as the US-China trade war escalates, which is prompting managers to seek more protection on their investments, as falling Libor rates eat into returns.

The Dow Jones Industrial Average dropped 767 points on August 5, as investors fled risky assets, but subsequently rallied. The 100 most widely held loans tracked by Refinitiv LPC dropped to 97.76 Wednesday from 98.15 on August 2.

Libor floor rates are also being increased to make struggling credits more attractive and some investors will not join deals without them. Middle market investors used to Libor floors in private credits may also demand that minimum levels are set when buying broadly syndicated loans.

“As Libor falls to new lows, (Libor floors are) something we are paying more attention to,” Mike Terwilliger, a portfolio manager at Resource Alts, said.

WestJet Airlines and CityMD increased Libor floors from 0% to 1% on a US$1.955bn term loan and a US$900m loan respectively this week, to make the loans more attractive to investors. Spokespeople for the banks arranging the financings declined to comment and spokespeople for the companies did not respond to emails requesting comment.

Libor floors reappeared during the financial crisis, when three-month Libor fell more than 80% to less than 1% in May 2009.

This guaranteed that investors would be paid the rate of the Libor floor, even if the actual rate was lower, and effectively removed the floating-rate nature of loans by fixing interest payments at the level of the floor plus the coupon.

As Libor began to rise, Libor floors were cut to 75bp and loan investors began to debate whether they were still required.

In early 2016, pet supplier Petco Animal Supplies was among the first issuers to add a tranche without a Libor floor to a financing backing its purchase by CVC Capital Partners and Canada Pension Plan Investment Board, and more companies followed suit.

LIBOR FLOOR PUSHBACK

Years of low interest rates and strong investor demand has allowed companies to pile on debt with loose documents and little lender protection, but investors are pushing for better terms as money continues to flow out of mutual funds while US rates fall.

Investors are finding that companies are more amenable to adding Libor floors than other requests, including restrictions on issuing additional debt.

Adding a Libor floor is “a little more achievable and the market will start paying attention” to that request, Terwilliger said.

Discussions have been complicated by the fact that Libor is set to be phased out by the end of 2021. Andrew Bailey, chief executive officer of the UK’s Financial Conduct Authority, in 2017 said there were insufficient transactions underpinning the rate after accusations bankers manipulated the benchmark.

The Fed recommends shifting to the Secured Overnight Financing Rate (SOFR), a broad measure of the cost of borrowing cash overnight collateralized by US Treasury securities. The loan market has been slow to adapt as there are no SOFR term options like one-month and three-month Libor to peg loan payments to.

Although Libor is falling, it may not fall far enough to trigger Libor floor payments before it is replaced.

“The market may see the demise of Libor before it reaches the level of any floor,” an investor said. (Reporting by Kristen Haunss; Editing by Tessa Walsh and Michele Sierra)