The London Interbank Offered Rate (LIBOR) transition is entering its final phase, with all remaining U.S. dollar LIBOR settings scheduled to phase out on June 30, 2023. U.S. corporate issuers and collateralized loan obligation (CLO) transactions with existing U.S. dollar LIBOR debt maturing after June 2023 will need to transition from LIBOR rates to new rates before or at the time LIBOR ceases being published. Secured overnight financing rate (SOFR)-based rates have emerged as the main replacement interest rates for dollar LIBOR; they, unlike LIBOR, do not incorporate a credit risk component. Like other securitizations with LIBOR exposure, CLOs have both assets and liabilities exposed to the benchmark, with different parties responsible for selecting replacement rates on each side of the CLO transaction.
Since Jan. 1, 2022, newly issued CLO transactions have used rates other than LIBOR, mainly CME Term SOFR. However, there are roughly 900 S&P Global Ratings-rated CLOs originated prior to 2022 whose liabilities still reference LIBOR. The pace of transition for these legacy CLOs has been slower than initially anticipated, mostly due to reduced corporate loan market issuance and prepayments in 2022.
To date, with about four months remaining until the June cessation date, we estimate that roughly 75% of leveraged loans and about 85% of rated U.S. CLO transaction liabilities are still indexed to LIBOR. Discussions among market participants around the upcoming transition of CLO assets and liabilities have intensified over the past several months, and we have received several queries from many market participants. We discuss some of the most frequent queries in this article.
Frequently Asked Questions
How is the U.S. CLO market impacted by LIBOR transition?
The relatively slow transition of interest rates among floating-rate corporate loans (and therefore slow transition of CLO tranches) has led to a mix of LIBOR- and SOFR-indexed CLO transactions and corporate loans in the market. Some of this uncertainty is due to the possibility that CLO transactions may use different credit spread adjustments (CSAs) or may change rates at different times. We've summarized some of our observations on CLO transactions by vintage of issuance:
2022-23 vintages: Transaction documents for these CLOs have generally been indexed to CME Term SOFR. This represents about 15% of our rated universe. To date, these transactions have been collateralized by portfolios of mostly LIBOR-based loans. These transactions will not need to transition their tranches; however, they may still be affected by the transition of the underlying leveraged loans away from LIBOR, and varying CSAs on those loans as they transition.
2018-21 vintages: Transaction documents for these CLOs generally contain relatively robust LIBOR fallback language that is similar to the Alternative Reference Rate Committee (ARCC)-recommendations. This represents a majority (60%) of our rated universe. This may lead to CLO tranches from these transactions transitioning to CME Term SOFR with a 26-basis-point (bps) CSA. Most CLO liabilities are floating-rate indexed to a three-month maturity, for which ARRC recommended fallbacks indicate a 26 bps spread adjustment (to account for five-year historical median difference between LIBOR and SOFR). The underlying loans would also need to transition away from LIBOR by June 2023. If corporate loans transitioned to SOFR with a lower CSA (<26 bps), this could reduce available excess spread.
2017-mid-2018 vintages: Transaction documents for these earlier-vintage CLOs contain a broad range of fallback language. Many of these transactions contemplated LIBOR cessation, but the fallback provisions are subjective and not very explicit. Such tranches would also need to transition away from LIBOR, but may lack an explicit path to a specific CSA. They sometimes refer to an index "endorsed" by third parties or an index being considered as the "industry standard" in the loan or CLO market. They may also refer to a "fair" or "appropriate" CSA to be used. These CLOs represent about 25% of our rated universe. Market participants expect this category to be heavily scrutinized. These deals will likely transition to CME Term SOFR, but there is uncertainty about the CSA to be used.
2017 and earlier transactions: Transaction documents for these CLOs generally did not explicitly contemplate a permanent LIBOR cessation, and the fallback language in these transaction documents includes approaches such as bank polling, fixing the rate at last quoted LIBOR, or no fallbacks. This group of transactions includes less than 5% of our rated universe. Given the weak or absence of fallback language in the CLO documents, liabilities may benefit from the Adjustable Interest Rate (LIBOR) Act of 2022, which establishes a legal safe harbor for determining persons applying a SOFR-based rate, likely CME Term SOFR + 26 bps spread adjustment for three-month maturities.
Do you expect any U.S. CLO ratings to be impacted by the LIBOR transition?
Our base-case expectation is that few CLO ratings will be affected. To the extent these rating changes do occur, we expect they would primarily affect CLO tranches rated in the 'BB' category or lower. (Ratings on tranches that have a larger reliance upon excess spread could be more likely to be affected).
A common question we have heard from CLO market participants involves the degree to which excess spread may change due to LIBOR transition. While there has been widespread agreement on SOFR as the replacement interest rate, agreement around the level of CSA between assets and liabilities has proven more elusive. In a CLO securitization, the CSA to be used on the asset (loan) side and liability side can differ. Most CLO tranches refer to the ARCC-recommended CSA (26 bps for three-month tenor), while the CSA on the leveraged loan side can vary widely, including some loans with zero CSA. The timing of rate transition among loans and CLO liabilities could also temporarily affect excess spread.
We performed a stress test on our rated U.S. CLOs (see "Scenario Analysis: LIBOR Transition, Excess Spread, And U.S. CLO Ratings," published June 30, 2022) to see how different levels of excess spread reduction resulting from the LIBOR transition might affect our ratings. We found limited CLO rating impact under likely scenarios (including 10 bps-15 bps excess spread reduction). Under this scenario, only a very small portion of reinvesting broadly syndicated loan (BSL) non-investment-grade (NIG) tranche ratings could be negatively impacted, and very few CLO (or none) investment-grade (IG) tranche ratings would be affected. In this analysis, we applied the excess spread reduction throughout the life of the transaction and did not give credit to manger's intervention.
Even under the more punitive scenarios we performed, including reducing annual excess spread by up to 26 bps, we saw limited rating impact. Additionally, we think that CLO managers may be able to mitigate the impact of these changes given their existing experience managing excess spread and basis risk (currently, a large majority of CLO assets are indexed to one-month LIBOR, while all existing CLO liabilities are indexed to three-month LIBOR).
To what extent might the Adjustable Interest Rate (LIBOR) Act affect the transition process for the U.S. CLO market?
In general, it appears that the federal LIBOR Act is unlikely to have a large direct impact on the CLO market. That's because most assets and liabilities already have some sort of specified fallback rate or provide for transaction party discretion to select a new rate. The law was designed mainly to assist "legacy" contracts where fallbacks are weak or lacking altogether to transition away from LIBOR.
The law specifically focuses on transactions with no fallback language, weaker LIBOR-based fallback language such as "the last quoted LIBOR," or bank polling-styled fallbacks. In these specific cases, the law would create a path to a SOFR-based rate (most likely CME Term SOFR) with 26 bps spread adjustments for a three-month maturity. For such transactions, the law would provide a "safe harbor" for transitioning rates to SOFR with the ARRC-recommended adjustment.
On the liability side, the majority of CLO indentures contain a specified replacement rate (as contained in ARRC-recommended fallbacks) or empower a transaction party such as a collateral manager to select a replacement interest rate. As a result, the LIBOR Act may only be applicable to very small portion of the CLO universe. We estimate that this group of transactions, usually older ones from 2017 and earlier, may represent less than 5% of the outstanding CLO tranches.
Similarly, on the asset side of CLOs, the majority of leveraged loan documents contain some sort of prespecified fallback rate such as the Prime Rate or ARRC-style hardwired fallback provisions. In both cases, the LIBOR Act would not appear to come into play. Of course, its ultimate applicability is very fact and contract specific, but generally, we don't view the LIBOR Act as having major applicability to CLO assets or liabilities.
Do U.S. CLO indentures typically grant discretion to a transaction party regarding the CSA that is used when they transition? Have you seen any CLO tranches transition using a CSA other than 26 bps?
These questions are central to LIBOR transition in the CLO market. The answers typically depend on the contractual, ultimate fallback language of each CLO transaction. We understand that most rated transactions have ARCC-like fallback language that usually uses a hardcoded 26 bps CSA. However, some transactions may not have a specific CSA concept in their indentures. Their fallback provisions are more subjective and may refer to a "fair" or "appropriate" adjustment to reflect the basis between LIBOR and SOFR.
However, the 26 bps CSA would usually kick in on the first interest rate determination date following the June 30, 2023, cessation date. Prior to June 30, 2023, CLO managers could issue a supplemental indenture to transition the liabilities to SOFR plus a CSA that they and the investors agree to. We have seen CSA proposals for less than the 26 bps ARCC-recommended spread adjustment level. To date, these proposals (on the CLO tranches) seem to have been objected to by controlling investors.
What have we observed on the corporate loan side regarding the replacement rates and CSAs to be used?
The majority of the leveraged loans issued or refinanced since Jan. 1,2022, have used CME Term SOFR. We have observed a variety of CSA levels applied on these loans (with some loans having zero CSA). There seems to have been some stabilization around 10 bps lately for CSA to be applied to leveraged loans. It is also worth comparing the pre-transition all-in interest rate to the post-transition rate as sometimes the CSA can be "baked' into the margin directly (making the implied CSA less transparent).
What language do we typically see in loan agreements when it comes to benchmark transition? How has this evolved since 2017?
Going back to mid-2017 (when the U.K.'s Financial Conduct Authority (FCA) announced that LIBOR would no longer be available after 2021 (which has then been extended to June 30, 2023)), we started to see fallback language specifically designed for the ultimate cessation of LIBOR. Before then, there was minimal guidance about fallback language. When compared to today's ARCC recommendation, those fallbacks were not comprehensive. Often in older credit agreements, the fallback language did not contemplate a new rate or the need to address the change when it occurs, only mentioning that LIBOR cessation was a possibility and granting the administrative agent the power to amend rates. Before these 2017 agreements, it was very common to find credit agreements that mention the inability to calculate LIBOR as a matter not related to the cessation of LIBOR, whereby the solution in such an event is to revert to the alternative base rate (ABR), which is often the Prime Rate, if available.
In 2018 and in 2019, a more direct approach developed, especially after the ARRC published its LIBOR transition recommendations. During this period, fallback language among leveraged loans was overwhelmingly placed as an attachment to the standard "inability to calculate LIBOR" clause. The direct language builds on the inability to calculate concept and provides a remedy if that inability to calculate LIBOR becomes permanent (e.g. the permanent cessation of LIBOR). Because LIBOR cessation was a few years out at that time, and there was no consensus or clear replacement benchmark, the amendment approach was the primary option utilized. Therefore, with few exceptions, the remedy for the permanent inability to calculate LIBOR is a good-faith negotiation between the borrower and the administrative agent to adopt a new benchmark--usually requiring them to select a current, market-favored replacement (subject to a negative consent by a simple majority of the lenders, by amount).
A significant number of the credit agreements we have reviewed that take this approach also mention, but do not necessarily require, some form of benchmark adjustment as the case may warrant either through necessity or it being the prevailing convention in the market at the time. Moreover, in any interim period between the cessation and the adoption of a new benchmark, most of the credit agreements have specific language noting that the ABR will be controlling during that period.
In 2020, with LIBOR cessation less than two years away (originally scheduled for December 2021) and the market considering several replacement benchmarks, loan credit agreements started to take on a more standardized approach in terms of language and structure, or at the very least, topics covered. We started to see specific trigger events that went beyond a permanent inability to calculate LIBOR to include some, if not all, of the ARRC's permanent- and pre-cessation triggers for syndicated loans. We also started to see ARRC-style transition dates. We observed a wider use of the affirmative consent from lenders as a requirement as well as the option for early opt-in to a new benchmark at the request of (depending on the credit agreement) some combination of the borrower, required lenders, or administrative agent (usually also requiring the affirmative consent of the required lenders). Despite this, the amendment approach was still widely used in 2020. However, some credit agreements using the amendment approach do reference SOFR as the likely benchmark replacement, and state that the negative consent/veto power given to lenders applies only to the CSA.
Yet, after the FCA's official announcement on LIBOR cessation in March 2021, the amendment approach used by many leveraged loans lost favor. In essence, a benchmark transition event (per ARCC guidelines) had occurred. The prevailing benchmark replacement convention at that time was SOFR. Since that time, many credit agreements have used the hardwired approach (with a SOFR option waterfall consisting of term SOFR and daily simple SOFR), while still allowing for the ability to switch over before the cessation through an early opt-in. These hardwired credit agreements also have CSA provisions/allowances, typically through a provision for a "benchmark replacement adjustment," which must conform to any adjustments set by the Federal Reserve Bank Board of Governors (or a body selected by them).
It's important to note that regardless of the approach used (amendment or hardwired), most leveraged loans will require an amendment to the credit agreement in order to transition, as even the hardwired setups require conforming changes amendments. This could lead to a situation where administrative agents and lenders find themselves overwhelmed by the number of amendments that need to be considered in a short period of time. Because of the high quantity of loans needing rate amendments by June (excluding those that contain hardwired fallbacks), loans that are unable to execute an amendment with replacement rates may go to a Prime Rate, which could pose financial challenges given the leveraged nature of most borrowers.
Of note, the above analysis is based on a sample of credit agreements we reviewed and is meant to provide a general overview of the progression of LIBOR transition language.
- Global Structured Finance 2023 Outlook, Jan. 11, 2023
- Advanced Notice Of Interest Rate Changes For Structured Finance Transactions Due To LIBOR Transition Requested, Dec. 8, 2022
- U.S. Interest Rates In A Post-LIBOR World, Sept. 22, 2022
- LIBOR Transition, Excess Spread, And U.S. CLO Ratings, June 30, 2022
This report does not constitute a rating action.
|Primary Credit Analysts:||Yann Marty, Paris + 1 (212) 438 3601;|
|John A Detweiler, CFA, New York + 1 (212) 438 7319;|
|Bek R Sunuu, New York + 212-438-0376;|
|Secondary Contact:||Stephen A Anderberg, New York + (212) 438-8991;|
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