NEW YORK (LPC) - 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, the largest buyers of the debt.
About 60% of issuers in the US$979bn US leveraged loan market are now using a one-month London interbank offered rate (Libor) contract, according to Citigroup, to reduce their borrowing costs.
Loans have become more expensive after a steep climb in Libor, and borrowing costs will rise further if US interest rates climb as expected. The Federal Reserve has increased rates six times since December 2015 and Bank of America Merrill Lynch is expecting two more hikes this year.
Rising Libor rates have pushed the gap between one-month Libor and the traditional three-month Libor to the widest levels since the credit crisis, giving a savings of 46bp on the shorter-term rate. Set by submissions from banks based on the rate they believe they would be charged to borrow, three-month Libor was 2.355% on April 17, compared to one-month Libor of 1.895%.
“The spread between one-month [Libor] and three-month is close to the widest it’s ever been and many issuers are contemplating switching to a one-month” contract, said Tom Shandell, chief executive officer at Marble Point Credit Management.
The move could reduce returns to investors in CLO equity, the most junior and riskiest tranche of the funds, by up to 3%, according to Citigroup estimates, and could also decrease CLO volume.
CLOs are losing out as they pay their investors a set rate plus three-month Libor from the interest payments they receive from companies, which are increasingly paying interest on the cheaper one-month contract. This is reducing the amount leftover to pay equity investors, who receive the interest remaining after the fund’s bondholders are paid.
“If you are an equity holder, the fact that loans are switching to one-month [Libor] is impacting quite significantly how you look at the risk and return profile of the equity you are holding,” said Laila Kollmorgen, a managing director at PineBridge Investments.
CLO funds sell tranches of varying risk to investors backed by a pool of loans made to large US companies and are a crucial funding source to borrowers that access the market to refinance existing debt and fund acquisitions and mergers.
The contract switch caused by the gap between the two Libor contracts could dent equity returns by 0.2-3%, according to Citigroup.
A 3% reduction could hit new CLO issuance, according to Maggie Wang, head of US CLO and Collateralized Debt Obligation research at Citigroup.
“It could drive expected equity returns to the high single digits, which could hurt CLO issuance,” she said.
There has been US$36.7bn of US CLOs issued this year through April 13, up 66% from the same period in 2017, according to Thomson Reuters LPC Collateral data. Citigroup is forecasting a record US$140bn of volume in 2018.
To eliminate the Libor mismatch, some participants in the US CLO market are suggesting that the funds should be allowed to match their tranche payments to the underlying loan payments. This would allow managers to switch their tranche rates to one-month from three-month contracts.
Debt investors are rigorously fighting this proposal and want to keep the mismatch, even though it may mean lower equity distributions, in order to protect their returns. Switching CLO debt tranches to a one-month Libor contract would mean lower interest payments for those investors.
A manager associated with investment firm Napier Park included language in a preliminary deal document for its Regatta X CLO late last year that allowed for Libor on the CLO tranches to reset to a rate “interpolating” between one-month and three-month Libor if at least 50% of the collateral is using the one-month rate. The provision was not included in the final deal.
Some CLOs that recently tried to include a one-month option faced pushback from debt investors and were unable to price the deal with that provision, sources said.
A Napier Park spokesperson declined to comment.
Lower CLO equity distributions are not deterring buyers, but are being taken into account when investors are determining purchase prices, PineBridge’s Kollmorgen said.
“Equity buyers are still there, they will just demand to purchase the tranche at a lower price,” she said.
Reporting by Kristen Haunss; Editing by Tessa Walsh and Michelle Sierra