Three-month Libor dropped from an average of 1.68% in January and February to a low of 0.74% in March after the Federal Reserve cut rates to zero to stimulate the economy as a result of the coronavirus pandemic. But by early April the base rate peaked at 1.44% as banks were willing to pay a higher rate for funds around quarter-end.

CLOs that made equity payments in early July had their liabilities benchmarked to peak early April rates. Three-month Libor then fell to 0.56% by the end of April and has continued to trend lower, seeing lows of 0.24%.

As a result, loans that paid monthly interest were therefore referencing a significantly lower base rate than CLO liability costs. At the same time, loan issuers were switching from paying monthly to quarterly in order to preserve liquidity, meaning some payments were not made in advance of CLOs’ July payment date.

“Given 60 to 70% of loans in CLOs are paying on a one-month Libor rate set at less than 30bp, and the rate set on CLO liabilities is around 125bp, that really digs into equity returns,” says Philip Braner, chief operating officer at Whitestar Asset Management in Dallas.

The result is a perfect storm for CLO equity. The Libor issue is compounded by the 24% of CLOs that are failing an over-collateralisation or interest diversion test. 16% of CLOs did not make a July payment, according to Bank of America.

Justin Driscoll, portfolio manager at Gallatin Loan Management, says the one-month versus three-month basis risk in CLOs is an issue that has flared up over the past several years: “There’s always this basis risk that some people don’t pay attention to until it hits them in the face.”

The technicals that dampened July equity returns should, however, play into CLO managers’ hands in October, Driscoll says. “Our sets on both deals were 27bp and Libor has nowhere to go but up”.

As has previously reported, 36% of the loan market has Libor floored at 1%, which will provide pick-up for managers on the next payment date, should both one and three-month Libor remain below that threshold. By contrast, CLO liabilities tend to be floored at zero, if they are floored at all.