CLO issuers sit on Sofr as they brace for short-term hit

Sayed Kadiri

Editor

Times are about as good as they get in the US CLO market, with new issuance breaking records as daily volumes in September regularly topped $2 billion, but in three months new CLOs will have to adopt Sofr as a benchmark and thoughts are turning to how the CLO industry will manage the accompanying basis risk.

It seems inevitable that CLOs will have a temporary mismatch between their assets and liabilities as the market gradually transitions from Libor to Sofr (not one Sofr-benchmarked US leveraged loan has priced as Creditflux goes to press).

Deborah Festa, partner at Akin Gump in Los Angeles, says there are ways of limiting this basis risk. “You could structure an interest rate ladder,” she says. “This could take into account the proportion of a CLO’s portfolio that is pegged to Sofr and feed that through to the CLO liabilities, moving up or down as the proportion of Sofr-linked loans fluctuates.”

“You could structure an interest rate ladder”

Deborah Festa, Partner | Akin Gump

For existing CLOs, there is a pathway to Sofr through the refi and reset market.

“The basis risk, as liabilities transition from Libor to Sofr, is unpleasant, but not long-lasting,” says Michael Kurinets, chief investment officer at Capra Ibex Advisors in New York. He says that refinancings or resets could be the most efficient way for CLOs to transition their liabilities to Sofr. Replacing old debt with new would mean CLOs avoid paying the adjustment spread from Libor to Sofr (this is set at 26 basis points by the Alternative Reference Rates Committee).

CLO managers have told Creditflux they are ready to print CLOs pegged to Sofr as soon as there are sufficient loans benchmarked to Sofr. However, managers will not always have control over the transition.

Festa says the majority of CLO documentation gives managers some discretion, but in the past four months, CLO triple A investors have demanded that managers make the switch if trigger events take place.

“There is a lot of variation in how CLOs will migrate to Sofr,” she says. “Most CLO indentures point to a benchmark replacement waterfall and the focus is going to be on the point in that waterfall which either gives managers the option of switching their liabilities to Sofr when more than 50% of their portfolio collateral is benchmarked to Sofr, or forces them to make the switch under that event.”

The percentage of loans benchmarked to Sofr within a CLO portfolio will be key over the coming months, says Kurinets. He says US CLO issuance will be likely be slower in the first quarter as market participants wait for a high proportion of loans to switch over to Sofr to dampen any basis risk.

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Global credit funds & CLO's

October 2021 | Issue 239

Published in London & New York.