| NEW YORK, Sept 8
NEW YORK, Sept 8 After eight years of fixed
interest rates, leveraged loans are poised to once again be
allowed to float freely, pegged to Libor, with the rate
borrowers pay lenders increasing as the benchmark rises.
Libor floors were introduced as a protection for investors
during the credit crisis to boost yields and make loans more
attractive as the benchmark slumped more than 80% from a 10-year
high in September 2007 to less than 1% in May 2009.
Libor has increased 152% to a seven-year high during the
last 12 months, moving the benchmark closer to 1%, an artificial
minimum most companies use to calculate interest payments. Once
Libor rises above 1% the US$880bn floating-rate loan market will
start floating again.
Ninety-eight percent of first-lien term loans issued in 2015
included Libor floors, according to Thomson Reuters LPC data.
Eighty-one percent of those loans had a 1% floor. More companies
this year - 9% in the third quarter through August 30 - issued
loans with a 0% floor or no floor.
Leveraged loans, as investment tools, are often pitched as a
hedge against rising rates because investors should receive
higher yields as rates increase. The introduction of the Libor
floor complicated that equation because even though the
benchmark has risen 36% this year, most investors have not
benefited because the floor sets the interest rate at a fixed
But once Libor rises above the floor, interest payments will
again be tied to the benchmark and lenders will receive higher
distributions, which may attract new investors to the asset
"Anything that clarifies and simplifies the story is going
to be very welcome," said Jeff Bakalar, co-head of Voya
Investment Management's senior loan group. "Loans aren't
terribly complicated, but the story has been muddied by the
Libor floor scenario. Once are a thing for the history
book, it will be one less complicating factor in the mind of
Libor has been rising ahead of October's money-market reform
deadline as a significant amount of assets have been transferred
to government funds from prime funds, which are large buyers of
financial commercial paper, Morgan Stanley analysts have said.
Libor has risen as financial commercial paper rates moved
In August, Federal Reserve Chair Janet Yellen said the case
for increasing US rates had strengthened, which may lead to a
further rise in Libor.
Three-month Libor was 83bp on September 7.
If the Federal Reserve chooses to raise rates this month,
Libor could move meaningfully higher more quickly than
anticipated, according to Mark Cabana, head of short-term
interest rate strategy at Bank of America Merrill Lynch, which
does not expect a September rate hike.
BAML forecasts three-month Libor will be 95bp at the end of
the year, he said.
Investor speculation that short-term US rates, and Libor,
may rise, could lead to more inflows into loan retail funds,
according to Trey Parker, head of credit at Highland Capital
"If we continue to see short-term rates rise, it could help
the landscape of the loan market," he said.
The recent jump in Libor has already led to five consecutive
weeks of inflows into loan retail and exchange-traded funds
through August 31, but is not enough to counter the general low
rate environment, which has led to more than US$5.4bn being
pulled from the funds in 2016, according to Lipper data. There
were outflows of US$21.6bn in 2015 and US$23.9bn in 2014.
The largest beneficiary of the floor has been the most
junior portion of Collateralized Loan Obligations (CLOs), the
largest buyer of leveraged loans. The floors led to about 7.5
percentage points of extra annual cash payments to these
investors, according to Mia Qian, a CLO analyst at Morgan
Stanley. But rising Libor may now threaten those returns.
CLOs, which pool loans of different credit quality, sell
slices of the fund of varying seniority, from AAA to B, to
investors such as insurance companies. Those debtholders are
paid a spread over Libor. The equity slice is paid last with
what interest is left over after the bondholders receive their
Due to the floors, the amount of interest loans pay to the
CLO stays the same. Payouts to the CLO debtholders, however,
increase because those tranches do not have floors. The mismatch
leaves less leftover for equity holders, causing their
distributions to drop.
"The biggest impact has really been toward the math of CLO
equity," said Brad Rogoff, head of credit strategy at Barclays.
"CLO issuance has been disappointing for a number of reasons and
not getting the benefit of the Libor floor is definitely a
negative effect on CLO equity returns."
There has been US$38.2bn of CLOs arranged this year, down
49% from the same time period in 2015, according to Thomson
Reuters LPC Collateral data. Volume is down, in part, due to
upcoming risk-retention rules that require firms to hold 5% of
As Libor has started to tick up, some companies have begun
to eliminate Libor floors all together.
Avago Technologies and Boyd Gaming were among the 9% of
companies in the third quarter that issued loans without a floor
or with a 0% floor, according to LPC data.
Still, with the majority of loans locked in with a floor,
until Libor rises above 1%, the fixed-rate coupon remains.
"There really hasn't been any period where a measured
increase in short-term borrowing rates has been anything but
positive for the asset class," Bakalar said.
(Reporting by Kristen Haunss and Jonathan Schwarzberg; Editing
by Michelle Sierra and Jon Methven)