After eight years of fixed interest rates, leveraged loans are poised to once again be allowed to float freely, pegged to Libor, with the rate borrowers pay lenders increasing as the benchmark rises.
Libor floors were introduced as a protection for investors during the credit crisis to boost yields and make loans more attractive as the benchmark slumped more than 80% from a 10-year high in September 2007 to less than 1% in May 2009.
Libor has increased 152% to a seven-year high during the last 12 months, moving the benchmark closer to 1%, an artificial minimum most companies use to calculate interest payments. Once Libor rises above 1% the US$880bn floating-rate loan market will start floating again.
Ninety-eight percent of first-lien term loans issued in 2015 included Libor floors, according to Thomson Reuters LPC data. Eighty-one percent of those loans had a 1% floor. More companies this year – 9% in the third quarter through August 30 – issued loans with a 0% floor or no floor.
Leveraged loans, as investment tools, are often pitched as a hedge against rising rates because investors should receive higher yields as rates increase. The introduction of the Libor floor complicated that equation because even though the benchmark has risen 36% this year, most investors have not benefited because the floor sets the interest rate at a fixed level.
But once Libor rises above the floor, interest payments will again be tied to the benchmark and lenders will receive higher distributions, which may attract new investors to the asset class.
“Anything that clarifies and simplifies the story is going to be very welcome,” said Jeff Bakalar, co-head of Voya Investment Management’s senior loan group. “Loans aren’t terribly complicated, but the story has been muddied by the Libor floor scenario. Once are a thing for the history book, it will be one less complicating factor in the mind of many investors.”
Libor has been rising ahead of October’s money-market reform deadline as a significant amount of assets have been transferred to government funds from prime funds, which are large buyers of financial commercial paper, Morgan Stanley analysts have said. Libor has risen as financial commercial paper rates moved higher.
In August, Federal Reserve Chair Janet Yellen said the case for increasing US rates had strengthened, which may lead to a further rise in Libor.
Three-month Libor was 83bp on September 7.
If the Federal Reserve chooses to raise rates this month, Libor could move meaningfully higher more quickly than anticipated, according to Mark Cabana, head of short-term interest rate strategy at Bank of America Merrill Lynch, which does not expect a September rate hike.
BAML forecasts three-month Libor will be 95bp at the end of the year, he said.
Investor speculation that short-term US rates, and Libor, may rise, could lead to more inflows into loan retail funds, according to Trey Parker, head of credit at Highland Capital Management.
“If we continue to see short-term rates rise, it could help the landscape of the loan market,” he said.
The recent jump in Libor has already led to five consecutive weeks of inflows into loan retail and exchange-traded funds through August 31, but is not enough to counter the general low rate environment, which has led to more than US$5.4bn being pulled from the funds in 2016, according to Lipper data. There were outflows of US$21.6bn in 2015 and US$23.9bn in 2014.
The largest beneficiary of the floor has been the most junior portion of Collateralized Loan Obligations (CLOs), the largest buyer of leveraged loans. The floors led to about 7.5 percentage points of extra annual cash payments to these investors, according to Mia Qian, a CLO analyst at Morgan Stanley. But rising Libor may now threaten those returns.
CLOs, which pool loans of different credit quality, sell slices of the fund of varying seniority, from AAA to B, to investors such as insurance companies. Those debtholders are paid a spread over Libor. The equity slice is paid last with what interest is left over after the bondholders receive their distributions.
Due to the floors, the amount of interest loans pay to the CLO stays the same. Payouts to the CLO debtholders, however, increase because those tranches do not have floors. The mismatch leaves less leftover for equity holders, causing their distributions to drop.
“The biggest impact has really been toward the math of CLO equity,” said Brad Rogoff, head of credit strategy at Barclays. “CLO issuance has been disappointing for a number of reasons and not getting the benefit of the Libor floor is definitely a negative effect on CLO equity returns.”
There has been US$38.2bn of CLOs arranged this year, down 49% from the same time period in 2015, according to Thomson Reuters LPC Collateral data. Volume is down, in part, due to upcoming risk-retention rules that require firms to hold 5% of their fund.
As Libor has started to tick up, some companies have begun to eliminate Libor floors all together.
Avago Technologies and Boyd Gaming were among the 9% of companies in the third quarter that issued loans without a floor or with a 0% floor, according to LPC data.
Still, with the majority of loans locked in with a floor, until Libor rises above 1%, the fixed-rate coupon remains.
“There really hasn’t been any period where a measured increase in short-term borrowing rates has been anything but positive for the asset class,” Bakalar said.
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