“Reuters – US leveraged loan borrowers are increasingly switching to a cheaper short-term Libor rate to reduce interest payments, which is squeezing the returns of some Collateralized Loan Obligation (CLO) investors…”
Here’s an interesting battle brewing in the structured credit world, which was borne out of recent developments in the debt markets that originated on rates desks across the pond. Got it? Good.
So, there is this thing called LIBOR, which stands for London Inter-bank Offered Rate. It’s the rate at which banks around the world are willing to lend money to each other for different short-term maturities: overnight, one week, and 1, 2, 3, 6 and 12 months. The longer the maturity, the higher the rate (for the rest of this blog, any reference to LIBOR means 3-Month LIBOR unless stated otherwise). Pretty simple. This rate is incredibly important because, logically, banks borrow money from each other at any LIBOR, add a few percent onto it (the spread), and then lend that money to retail and commercial clients (think car loans, credit cards, mortgages, corporate loans, revolving credit, etc.).
Some of those commercial clients are companies with poor balance sheets that need to borrow capital to operate, so they’ll tap what’s known as the leveraged loan market to do so. In a leveraged loan transaction, a bank will arrange and structure the loan, then sell pieces of it to other banks or investors to transfer some of the risk in a process known as syndication. Because the company borrowing already has a poor balance sheet, the participating banks view them to be at a higher rate of default and that is factored into the interest rate they charge, which is typically LIBOR + the spread (normally between 200 – 500 basis). Now, the thing with loans tied to LIBOR is that it changes every single day. Because of this feature, banks will usually reset the coupon every month or two in order to reflect whatever the current LIBOR is. It’s for this reason that you’ll see the terms leveraged loan and floating-rate loan used interchangeably. It just means that the interest rate on the loan changes periodically based on where LIBOR is moving (and you should check your credit card – I bet your interest payments are ticking up, as they’re floating-rate as well).
We said before that when a loan is syndicated, other banks and investors buy a piece of it and receive their portion of the interest. We know what a bank is but who are the other investors? CLOs. These are shell companies that go out and buy a bunch of different loans, structure their cash flows into debt tranches and sell them to asset managers, pension funds and insurance companies as investments. The debt tranches are just like bonds, each having a credit rating and an accompanying coupon payment based on the credit risk an investor is taking. There is also something called the equity tranche. Investors here are taking the most risk and only receive interest payments after all of the debt tranches have been paid off. Now, let’s get to the good stuff.
The post-crisis era has been a boon for the leveraged loan and CLO markets. Rates were low, so risky companies were able to borrow and investors were searching anywhere for yield, so demand for CLOs skyrocketed. Alas, the party wasn’t going to last forever, and now we have quite the credit quandary on our hands. 3-Month LIBOR has gone parabolic since about Thanksgiving 2017, which means that loan interest payments are ticking up in lockstep. No worries, though, we have a fix for that. Like we mentioned before, these loans are floating-rate, so their interest rates reset every month or two. Wouldn’t you know it, creditors are resetting these loans at the much cheaper 1-Month LIBOR in order to ease the interest burden on companies and prevent defaults. That seems great, and it is, for the banks and the companies that borrowed. CLOs aren’t enjoying it as much. See, the CLOs issued the debt tranches at fixed coupons which were tied directly to the interest they expected to generate from loans referencing 3-Month LIBOR. However, the underlying loans are now paying less interest as they reference the cheaper 1-Month LIBOR, which has created a mismatch between the CLO’s assets and liabilities. As a result, you have CLO managers trying to renegotiate coupons on tranches they promised to investors to reflect the cheaper rate, but investors are saying, “no thanks”. Can’t really blame them for not willingly accepting a lower return, can you? At the end of the day, these CLOs are taking in less money than they’re paying out, so someone needs to lose.
Raise your hand if you’re thinking “equity tranche”. That’s correct, these guys are gonna get smoked. They only receive what’s left over after the debt tranches are compensated, so any shortfall in funds will erode returns for these guys and impact what investors are willing to pay for an equity tranche in the secondary market – and that will also impact new CLO issuance as investors require more yield for their risk. At the end of the day I don’t think you’ll see any material impacts here, but you’ll most likely see funds write down some positions and perhaps a downtick in new issuance. The structured credit markets have always been fans of ingenuity, though, so I have no doubt they’ll come up with a mechanism to rectify this hiccup as well.