Sofr spike boosts CLO debt as Europe and US go out of sync

Sayed Kadiri

Editor

The sharp rise in three-month term Sofr has caused CLO relative value to shift decisively towards primary US CLO debt tranches in January as the floating rate benchmark shot up from 9.11bp to 17.06bp (from 1-20 January). Over the same period, three-month Libor added just 4.3bp to land on 25.89bp.

This sharp swing has created some confusion as to what the credit spread adjustment should be for new deals that are adopting Sofr, with the spot basis between three-month Sofr and Libor shrinking to just 8.83bp.

“Three-month Sofr has risen sharply this year and the mechanics of the spread adjustment mean that, in the short-term, it is best to invest in primary US CLO debt tranches compared to primary US equity,” says Matt Layton, a partner at global CLO investment firm Pearl Diver Capital.

The spot basis is much lower than the Alternative Reference Rate Committee’s recommended 26bp spread adjustment. It is also lower than the adjustment being used in the primary CLO market. “It’s about 10-15bp, but this is being baked into the overall margin, rather than explicitly labelled as a spread adjustment,” says a New York dealer.

“It is best to invest in primary US CLO debt tranches compared to equity”

Matt Layton, Partner | Pearl Diver Capital

Despite dealing with the transition to Sofr, five new US CLOs have priced this year. There have been no new European deals. Layton says Europe is due to price its first primary CLO this week, as Creditflux goes to press, and more will follow soon afterwards. The pipeline in both the US and Europe looks strong simply based on the record number of warehouses open.

“As much as the increase in US interest rates is a relative positive for CLO debt, especially when compared against fixed income products, it is going to mean that CLO equity investors will at some point lose the benefit of Libor floors on loan assets,” he says.

“In Europe, the ECB is taking a more dovish stance and that means floors are still in the money. Instead, geopolitical risks in eastern Europe and the threat of a steep rise in energy prices are the more obvious risks. However, some volatility is likely to create a real opportunity for investors with cash.”

That said, European CLOs are well placed to absorb any volatility, as they did through 2020.

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Global credit funds & CLO's

February 2022 | Issue 242

Published in London & New York.