Several collateralized loan obligation managers, including Och-Ziff Capital Mgmt Grp affiliate Och-Ziff Loan Management, Goldman Sachs Asset Management LP and Trinitas Capital Management LLC, have recently issued deals that automatically convert their CLO liabilities to the secured overnight financing rate if the London interbank offered rate is no longer quoted at a future date — the first of their kind to do so, according to market sources.
The addition of such language might suggest that a growing share of market participants are beginning to believe that "the world’s most important number" might not have a shelf life beyond the end of 2021.
Until recently, most CLO managers planned to rely on future contractual amendments to shift to a replacement rate for Libor, leaving room for flexibility but potentially causing a tsunami of legal headaches and value-transfer at the time of transition.
In contrast, a crop of new deals are choosing "hardwired" fallback language. This dictates that, were Libor to cease, CLO liabilities would automatically fall back to some version of Sofr, plus a spread adjustment, that will be set out by the International Swaps and Derivatives Association, or ISDA, by year-end. Sofr is published each business day by the New York Federal Reserve.
In one such deal, HPS Loan Management 15-2019, the documentation specifies that once the CLO manager determines that Libor will no longer be quoted, a waterfall of alternatives emerges to replace the given Libor rate, first with forward-looking term Sofr plus an adjustment, and next with compounded Sofr plus an adjustment.
Although many in the market say they are not sure whether Sofr will be ready for use by the time Libor ends, supporters of the hardwired approach point out that compounded Sofr can already be calculated, and with an imminent publication of spread adjustments from the ISDA, a workable alternative for the Libor transition is effectively in place for CLO liabilities.
"We believe that the movement toward hardwired fallbacks is a very positive thing," said Meredith Coffey, executive vice president of research and regulation at the Loan Syndication and Trading Association. "Hardwired fallbacks will increase transparency and certainty, and will significantly reduce the odds of market disruption."
However, several market participants say they are hardly enthusiastic about a hardwired commitment to Sofr and suggest that one large AAA investor that sits on the Alternative Reference Rates Committee, or ARRC, is driving nearly all the adoption of hardwired language.
In particular, CLO equity investors claim they are sensitive to rate changes endangering any part of the excess spread they earn from a loan portfolio, which generates the entirety of their returns.
"Versus other equity shops, we’re frankly agnostic whether Libor or Sofr [is] chosen as a replacement rate," said one CLO equity investor. "But we're not agnostic to mismatched funding. So whatever the underlying assets reference, the liabilities have to reference [that] as well, and we haven't signed up for the hardwired approach since nobody knows which way the loan market is going.
"The loan market needs to figure out what's coming, and get issuers on board, and have that be the new standard. Until then, you need to preserve flexibility in the docs themselves."
A banker who arranged one of the hardwired deals agreed that inertia from inside the loan market was not helping to change matters for CLOs.
"As the ARRC gets more squarely behind Sofr, I think there is an increasing push from investors at the top of the capital stack to follow their guidelines more stringently," the banker said. "The market would have trended there, but equity investors are worried that loans haven't already taken on that guidance."
Sources added that, if between trade associations and the loan market at large there was more definition around the best course of action, much of the ongoing negotiations between equity and AAA players, along with managers, might subside.
One investor for an institution that anchored the AAAs in a deal with hardwired language hinted, however, that it was not merely concerns from CLO equity investors that present potential roadblocks to Sofr adoption.
"Something like this is never easy, and it hasn't just been equity investors who have presented some opposition. It's been the bankers who have to learn something different and lawyers who are pressed to spend extra time toying with and amending contracts," the investor said.
"But all that being said, as people get more familiar with Sofr contracts and more folks start using a hardwired approach, it becomes more palatable. We hear a lot of support for risk management panels at banks once they assess what hardwired deals imply. Success begets success."
Whether the CLO market as a whole adopts the hardwired language will be a question decided in due time, as some CLO managers say they will only routinely adopt the approach if enough investors ask for it.
"I don't think the language in other deals was unreasonable," said a manager of one of the hardwired deals. "That documentation still references a separate reference rate that's approved by regulators and trade associations. If we were to do another deal, we'd default back to that language unless the AAA investors insisted upon it again. It depends on how the rest of the market embraces the concept, and I don't know if large domestic buyers will take a hard line, or care that much."
In 2017, the U.K. Financial Conduct Authority announced it would no longer mandate panel banks to submit Libor estimates after the end of 2021 on the grounds that interbank lending markets had become so inactive since the 2008 financial crisis that Libor had ceased to be a robust and useful reference rate for financial transactions. That same year, the ARRC, a group of private-market participants convened by the Federal Reserve Board and the Federal Reserve Bank of New York, selected Sofr as the preferred alternative to U.S. dollar Libor.