SOFR forward recommendation eases transition from CLO to Libor

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The transition away from Libor, the current benchmark for most floating rate loans, has recently been much easier for the CLO market with the recommendation of a forward-looking forward rate by a key legislative body, but important questions remain. .

On July 29, the Alternative Reference Rate Committee (ARRC), sponsored by the Federal Reserve and composed of a range of financial market participants, formally recommended a forward looking term structure for the guaranteed overnight funding rate. (SOFR), the replacement of the privileged Libor by the regulators. rate. In comments last year, regulators suggested restricting such a rate to financial markets where this forward-looking view is essential to their operation, a condition that would exclude commercial lending.

A potentially thorny scenario

If this restriction had been in place, the price of the loans should have been higher than the overnight SOFR rate. The interest payments calculated over the term in question should have used one of the four methodologies. Commercial borrowers and many lenders feared that such an arrangement would be operationally complex and that the final rate payable would only be known almost at the end of each term, which would make it more difficult to forecast cash flows. future. As a result, attention turned last spring to the Bloomberg Short-Term Bank Yield Index (BSBY) and other emerging Libor replacement rates offering forward-looking term structures, potentially resulting in a rate market. fragmented variable.

Such a scenario would present potentially thorny complications for CLOs. Regulators want all new transactions to be priced at a Libor replacement rate from 2022 and all existing transactions by July 2023. Thus, CLOs could end up holding loans priced at a variety of replacement rates. Libor largely untested and structured differently, increasing basis risks.

This could still happen, as the ARRC recommendations carry significant weight but are not official regulatory requirements. However, a forward-looking SOFR should greatly facilitate the transition from the huge volume of legacy Libor loans with similar term structures. Additionally, many commercial loans already favor the SOFR term as the fallback rate when Libor ends, and federal regulators and big banks favor it.

“That kind of certainty allows people to plan and sort out the details – change the language if they need to, refinance, set deadlines, etc.” said Daniel Wohlberg, director of Eagle Point Credit Management. “It leaves less doubt about what happens with these legacy contracts.”

A migration problem

J. Paul Forrester, partner at Mayer Brown, said the main issue for CLOs will be the migration of underlying loans from Libor by July 2023. Managers will need to coordinate the transitions of the underlying loan portfolios and CLO securities. , and investors will have to bear or hedge the resulting basis risk, although such hedges do not yet exist and can be relatively expensive.

Another consideration, Forrester said, is that some CLO contracts may have triggers requiring securities from a CLO to transition to a replacement rate even before the 2023 deadline. This could happen in existing agreements though, for example, secured loans priced above a replacement rate reach the majority of the loan pool, creating unexpected basis risk.

“Players in the CLO market would do well to think carefully about alternative structures for Libor in CLO contracts over the next few months, which could limit basis risk over the next two years,” Forrester said.

Specific to the operation of CLOs, transactions must undergo interest coverage tests, requiring administrators to measure whether and by how much interest on loans exceeds interest on liabilities, said Meredith Coffey, executive vice president and co- public policy manager at the Loan Syndications and Trade Association (LSTA).

“If you don’t know your interest rate until the end of the period, this process becomes more complex,” Coffey said. “Things like that make forward rates useful.”

Make day-to-day decisions

At this point, few loans have been priced above Libor replacement rates, and although large syndicated loans that end up in CLOs should primarily use the term SOFR, some may opt for a daily SOFR depending on needs of borrowers. Others may choose BSBY or another alternative rate that, like Libor, incorporates credit risk under market stress, which SOFR does not.

“We do not yet know for sure with what base rate the new agreements will be issued,” Wohlberg said, noting that so far there has been little indication of the imminent arrival of heavily syndicated loans in the market. priced higher than one of the Libor replacements. “We are seeing the push and pull between borrowers, lenders and sponsors, the entities closest to the accumulation and overnight payment of these interest rates.”

Any reluctance to adopt the term SOFR may stem in part from the historically low SOFR and three-month Libor rate levels, which most syndicated loans cost. The “spot” spread differential between them is only around nine basis points, whereas historically it has been much wider because SOFR is a risk-free rate and Libor includes bank credit risk. To account for this difference, the ARRC recommends applying a spread adjustment of 26 basis points for three-month Libor contracts, based on the historical relationship of the two rates over the past five years, when the loans move away from Libor in 2023.

“The difference between the lower spot spread differential and the higher ARRC Recommended Spread Adjustment can create tension between lenders and borrowers,” Coffey said. “The ARRC spread adjustment is the most historically consistent adjustment, but borrowers might not care and may want to pay the lower spot spread. “


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