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Leveraged-Loan LIBOR Floors Help U.S. CLO Notes in Low Rate Environment

April 03, 2020, 09:30 AM
Filed Under: Industry News

LIBOR floors in US leveraged loan agreements can provide some cushion to US CLOs, which is supportive to credit when benchmark rates drop as seen during the current market turmoil linked to the coronavirus pandemic, Fitch Ratings says. Leveraged loans generally have floors of zero or more, while CLO liabilities often set floors at zero. In a low rate environment, the higher floor for leveraged loans would make the excess spread available to the CLO as credit support in case of cash flow diversion.

Three-month LIBOR (3mL) is the index for CLO notes, and basis risk can exist when US leveraged loan interest payments reference one-month LIBOR (1mL) instead of 3mL. A sizeable positive difference between 3mL and 1mL can lead to reduction in excess spread. For more details, see our special report: Interest Coverage Erosion in U.S. CLOs (Beyond Reference Rate Mismatch of Loans and CLO Notes). Both 3mL and 1mL dropped precipitously as the Federal Reserve eased monetary policy in response to coronavirus pressures on the economy: 3mL fell to 0.74% on March 12 from 1.75% at the end of January, while 1mL fell to its lowest level of 0.61% on March 16 from 1.66% at the end of January, as accessed via FRED, Federal Reserve Bank of St. Louis. Below 1%, the use of LIBOR floors in some US leveraged loans held by CLOs were triggered but not on the CLO notes.

Among US leveraged loans in the Credit Suisse Leveraged Loan Index, nearly all include a floor, according to LevFin Insights, a Fitch Group company. Just over half are set at zero, with most of the remainder specifying a floor of 1%. A number of issuers that were in the market in early March had their deals flexed to a 1% floor amid the falling rate. The rate cuts by the US Federal Reserve will also likely make LIBOR floors at 0%, or otherwise standard in new loans when activity returns, says LevFin Insights.

The benefit of floors will be capped for most CLOs. Of the nearly 850 US CLOs rated by Fitch, including broadly syndicated loan (BSL) and middle market (MM) CLOs, 85% have a LIBOR floor of 0% on at least one note, generally at the top of the capital structure, with 72% having a 0% floor on all notes. There are no notes with a floor above 0%. Those CLO indentures that do not specify a LIBOR floor tend to be older transactions. Of the CLO transactions that originally closed in 2014 and 2015 and remain outstanding, 44% and 64%, respectively had LIBOR floors on at least one note compared with at least 88% for CLOs that originally closed in 2016 and later. Of the deals that have closed this year 90% include a LIBOR floor on at least one note in the transaction.

More than 60% of the CLOs had a floor for an alternative benchmark rate (ABR) as well, which would come into play when LIBOR becomes unsupported, which is expected after 2021. About 20% had a LIBOR floor but were silent with regard to a floor in the case of an ABR. The 58 US MM CLOs and 788 BSL CLOs reviewed were about equally likely to have LIBOR floors on at least one note, at 86% to 85%, respectively, while MM CLOs were more likely than BSL CLOs to have both a LIBOR floor and ABR floor, 72% compared with 61%.

Read more and view accompanying charts here.

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