CLOs face uncertainty as Libor rate deadline looms

Dan Alderson

Deputy editor

Charlie Dinning

Data journalist

CLO equity valuations could be increasingly under the spotlight in coming months, as sources warn of disruption while the market grapples with basis risk between Libor and Sofr in loans and CLO notes.

Sofr-linked CLO issuance is set to step up before the end of the year, given US regulators have marked this as the cut-off beyond which no new contracts should contain Libor as the reference rate.

The Alternative Reference Rates Committee (ARRC) has formally recommended CME Group’s term Sofr as Libor’s replacement. But concerns have mounted that the spot basis between the rates is at odds with adjustments suggested by the ARRC.

“The ARRC set the basis between Sofr and Libor at 26bp and the basis today is 8bp,” says Dan Ko, portfolio manager at Eagle Point Credit Management, referring to three-month reference rates. “So equity investors are not incentivised to move over to Sofr until the last moment as they’ll need to pay the extra difference to the debt.”

“Equity investors are not incentivised to move over to Sofr until the last moment”

Dan Ko, Portfolio manager | Eagle Point Credit Management

A last minute move to Sofr may cause basis risk and a wobble in the CLO market in January 2022, Ko believes.

ARRC’s recommendation for one-month adjustment was 11bp, while today’s spot basis is more like 5bp. In a recent research note, Bank of America credit strategists wrote that new issue loan borrowers have a free option to switch between tenors and are likely to select one-month Sofr as their tenor, considering the lower spread adjustment, and thus the lower coupon.

“This raises important questions for CLO equity valuations going forward as new issue loans would start referencing Sofr and the basis risk would increase,” said BofA.

“Additionally, in periods of credit stress Sofr is likely to remain low versus Libor and thus Sofr-linked bonds would see more price volatility versus Libor-linked bonds.”

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Global credit funds & CLO's

September 2021 | Issue 238

Published in London & New York.