Fixed-rate CLO tranches emerge ahead of rate rises

Sayed Kadiri

Editor

Floating rate benchmarks — whether Sofr or Libor — have risen sharply this year ahead of interest rate hikes in the US, and that has coincided with a flurry of new issue CLOs that have incorporated fixed-rate debt tranches.

Fixed-rate CLO notes are priced over swap rates and run to the weighted average life of the bond (roughly eight years for double A-rated CLO tranches).

According to one structurer, investors are accepting 20-30bp tighter spreads compared to floating rate equivalents. In mid-February, Trinitas X reset double As at 3.675%, equating to 185 basis points over swaps, with a pari passu floating rate bond pricing at 205bp.

However, on an all-in basis, fixed-rate CLO triple As priced 125-140bp wider than floating rate equivalents in the US primary CLO market in February. Six months ago that differential was just 80bp.

“At first glance, a fixed-rate tranche might appear expensive,” says Rachel Russell, Morgan Stanley’s head of US CLO new issues. “But with the prevalence of refi and reset technology, investors have the option to refinance after a couple of years, so they may not run to their stated weighted average life.”

“Equity investors can refinance fixed-rate tranches after a couple of years”

Rachel Russell, Head of US CLO new issues | Morgan Stanley

Russell adds that fixed-rate tranches give CLO issuers access to a different buyer base (predominantly insurance companies).

29.2% of new US CLOs this year have incorporated fixed-rate tranches, according to Creditflux data. This is up from 27.8% in 2021 but far short of the 47.1% in 2020, when floating rates collapsed.

Three-month Sofr started 2022 at 9.11bp and had climbed to 37.07bp by 18 February. Over the same period three-month Libor rose from 21.6bp to 47.96bp — maintaining the roughly 10bp basis between the two benchmarks.

New York-based Tal Reback has been responsible for KKR’s global Libor transition effort and says the spike in Sofr should not come as a surprise. “We have become so used to low spreads we forget floaters can float,” she says. “Although, Sofr is a risk-free rate it will follow the Federal Funds Rate.”

Reback sees a rapid transition to Sofr for legacy assets as a priority this year. “Three-month Libor is moving in-step with Sofr for now, but liquidity will dry up later this year and that could seep into pricing for assets that are slow to migrate,” she says.

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Global credit funds & CLO's

March 2022 | Issue 243

Published in London & New York.