(Bloomberg) -- The money managers that put together collateralized loan obligations are scrambling to get deals done before early next year, when the market undergoes a potentially messy transition to a new benchmark rate. 

That means that the record-setting pace of collateralized loan obligation sales this year is probably going to be followed by a much slower first quarter of 2022. The multi-step process of moving away from the London interbank offered rate will require migrating to at least one new standard benchmark for leveraged loans that get bundled into CLOs, as well as for the bonds that CLOs issue to fund themselves.   

Getting to the point where new conventions are established could be difficult. Libor must be retired for new loans no later than Dec. 31. CLOs starting in the first quarter of next year may be buying loans from late 2021 that still reference Libor, as well as newer loans that reference other benchmarks such as the Secured Overnight Financing Rate. 

All that may create mismatches between a CLO’s assets and whatever benchmark its liabilities use. These kinds of difficulties might cut into issuance of the securities at the start of 2022, said Paul Norris, managing director and head of structured products at insurance asset manager Conning.    

“We think a large part of the issuance we’re seeing now is getting in front of the Libor transition happening at the end of the year,” Norris said in an interview. “Managers want to issue under the Libor regime while they still can.”

Read more: Growing CLO Market Has a Libor-Transition Problem on the Horizon

Morgan Stanley CLO strategist Charlie Wu agrees. 

“Supply will remain elevated in the fourth quarter as managers look to get ahead of the looming basis mismatch,” Wu said. “2022 issuance will start slow as the sector will need time to adjust.”

CLO market issuance may reach a fresh annual sales record as soon as this week, breaking through 2018’s peak year of $130.4 billion, according to data compiled by Bloomberg. But the potential mismatch between the benchmarks that a CLO uses for its liabilities and the assets it invests in could add a new layer of basis risk -- the possibility of losses or gains due to different reference rates -- to an already complex product. 

CLO prices could become more volatile, and there’s a chance of reduced returns to CLO equity holders, who hold the riskiest slice of a deal and are the last to be paid, but can earn the highest potential payments. 

CLOs already suffer from some basis risk with leveraged loans -- most leveraged loans are pegged to one-month Libor, while CLOs are priced off three-month Libor -- and the transition away from Libor exacerbates it.

Equity Hit?

Depending on the combination of rate mismatches between assets and liabilities, annualized CLO equity returns to investors can shift as much as 1% to 2% in either direction when equity is considered at par, Deutsche Bank analysts said in a research note this week. The analysts looked at mismatches involving SOFR.  

“SOFR-linked leveraged loan issuance in the primary market is likely to gather pace in the fourth quarter,” said Deutsche Bank analysts Conor O’Toole and Keyur Vyas. “CLOs, on the other hand, are likely to hold back any SOFR-linked issuance in the near term until further clarity emerges in the underlying loan market.”

Libor is currently lower than term SOFR plus a spread adjustment, meaning that a hedging mismatch is sure to exist. 

There are several possibilities:  After Jan. 1, there may be new CLOs that pay in SOFR, but have a mix of underlying Libor and new-issue SOFR loan assets.  And for existing CLOs, there may be deals paying in Libor while once again the underlying loan assets could be a mix of Libor and SOFR. To make matters even more complicated, the assets and liabilities each can potentially pay in one-month or three-month Libor, versus one-month or three-month SOFR.

CLO liabilities have long paid in three-month Libor. But looking at various Libor/SOFR scenarios for a recently priced standard CLO structure, Deutsche Bank found that if the CLO switched to payments in three-month SOFR, and the loan assets moved to pay in one-month SOFR, there could be a decline in annualized CLO equity distributions of 1.1%.

CLO asset managers putting together portfiolios may be able to use the rate mix of underlying loans to their advantage, market observers say. 

“CLO managers will be able to buy Libor (loan) paper, or SOFR paper,” said Christopher Jackson, a partner at the law firm Allen & Overy. “It will be interesting to see how much variety banks offer their borrower clients, as far as type and tenor of rates. Shrewder CLO managers will be able to increase the arbitrage based on a little bit of rate arbitrage.”

Fallback Language

Libor is being eliminated out of concern it can be manipulated, and as underlying trading informing the rate has dried up. Regulators told U.S. banks to end Libor origination “as soon as practicable” and no later than December 31 of this year. The U.S. dollar rate will be retired for good from all transactions by June 2023 at the latest.

While some CLOs have so-called fallback language in their documentation governing the cessation of Libor, some still don’t. 

In a bit of good news for investors, this year’s record CLO refinancing wave has allowed managers to amend documents on many existing deals to include the latest fallback language by the Alternative Reference Rates Committee, a group put together by the Federal Reserve and the New York Fed to help with the transition.

Still, if a CLO’s documents are unclear on the matter, managers may have to get consent from debtholders, who hold the controlling class of the transaction. Switching the benchmark can become more complicated in this instance, since controlling classholders will do what benefits them most, and may be different from what the CLO manager wants, according to Deutsche Bank analysts.

Luckily, must of the recent CLO issuance of the past twelve to eighteen months has deal language whereby a switch to SOFR will take place 60 calendar days after notice of a benchmark transition event is given. 

“You’ve got all the paper issued in the last two years having some meaningful provision for what happens when Libor disappears,” said Allen & Overy’s Jackson. “From a legal perspective, it doesn’t pose a host of legal issues in the short term. Various forms of documentation contemplate SOFR, and the topic is pretty well vetted. The issue is, what do we do with new-issue deals dominated in SOFR on day one?”

Relative Value: ABS

  • Conning likes so-called recurring-revenue ABS, which may be interesting as a possible place to find yield, as well as venture-debt related ABS, triple net lease deals, and railcar ABS, especially securities found in the secondary market, Norris said in an interview
  • Norris also likes single-A and BBB rated aircraft lease ABS, as the spread and duration still looks relative attractive versus other sectors
  • The company also likes the top part of the capital structure of CLOs, anything AAA down to single-A, Norris said
  • Right now, Conning does not look at CRE CLOs, and doesn’t like the current valuations in supbrime auto ABS

Quotable

“The real issue in the market now is complacency,” Conning’s Norris said. “There’s not a lot of tremendous relative value out there. Now is the time not to be super-aggressive.  It’s the time to stay ‘close to home’ in terms of risk taking; to wait for opportunities and see.”

What’s Next

ABS deals in the queue include SoFi Lending (consumer loans).  ABS-15Gs were also filed by OneMain (auto), Golub Capital Partners, J.G. Wentworth, and PFS Financing Corp.

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