NEW YORK (Reuters) - Managers of Collateralized Loan Obligation (CLO) funds and bank loan mutual fund investors are worried that higher U.S. Libor rates will see smaller CLO equity payouts that will reduce managers income and will also pull secondary loan pricing lower.
Libor rates, which are expected to rise along with U.S. interest rates, are primarily a problem for CLO managers. CLOs raise funding on a floating-rate basis, but their loan interest income is temporarily fixed, which will squeeze returns.
Higher Libor rates will reduce the excess spread that investors receive and reduce returns for CLO equity holders after senior tranches are paid out - until Libor rates are higher than Libor floors.
Coupon payments on loans, which make up the asset side of CLO balance sheets, will not rise until Libor rates exceed Libor floors, which market players estimate will take 18 months.
However the liability side of CLOs balance sheets, which finances payouts to CLO equity holders, is floating rate and will rise along with Libor, which will cap returns in that time.
"As a CLO manager I'm happy to have Libor stay below 1 percent. That time when Libor starts increasing until it is above the floor will be painful for CLO equity investors," a CLO manager said.
U.S. leveraged loans typically offer margins of around LIB+250 along with Libor floors that guarantee returns for investors. Libor floors averaged 100bp in the second quarter, according to Thomson Reuters LPC data.
Investors currently make most of their money on excess spread, which is the 75bp difference between the current U.S. Libor rate of 23bp on June 5 and Libor floors of 100bp.
"Most of the excess return generated today in the U.S. (loan) market is from the Libor floor. As you erode that, it will deliver lower returns. Any rise in Libor reduces excess spread by the corresponding amount," a fund manager said.
Lower CLO equity payouts are another headwind for CLO managers to deal with and could hinder CLO issuance, along with federal risk retention rules and Volcker regulations.
The link between higher Libor rates and returns may not be quite as straightforward. Wider spread margins could increase loan cash flows even if Libor goes up, which could keep CLO equity distributions at the same level, sources said.
CLO managers could also call for Libor floors to be removed, the pricing of Libor floors to be adjusted or for loan margins to be increased to offset any impact. CLO 2.0 structures have the option of repricing debt tranches, but this is seen as unlikely.
"Three-month Libor remains in the 25bp area, so for the moment, most CLO buyers are content to keep the status quo and include a Libor floor in the financing terms," a second CLO manager said.
Libor floors are a relatively recent development and the temporary hiatus that they will create before income rises could make leveraged loans look less attractive as they were originally marketed as a floating rate product where income would rise along with rates.
"What will investors do when they see Libor rise and are getting no additional income from their loan holdings?" the fund manager said.
Lower secondary prices?
Libor floors could turn into Libor wars as higher Libor rates could depress the secondary loan prices of loans trading over par, banking sources say.
Although Libor floors will stop coupons increasing until Libor rates pass Libor floor levels, the cash flows that secondary loan prices are based on could be discounted at a higher rate.
Some analysts disagree that the delay in rising coupons will hit secondary loan prices. Citigroup noted in an April 11 noted that higher Libor will boost the value of the floating-rate component of loans and offset higher benchmark rates.
Loans trading over par have repricing risk, so a loan trading at 100.5, for example, could trade even higher with stronger call protection, the report said. The loan could continue to trade at 100.5 if Libor rises, as repricing risk could be hiding the loan's true premium.
"We conclude that we really don't know how prices will react to the first Fed rate hikes, but we believe there will be far more important factors to consider than the delay in rising coupons," the report said.
Any pain suffered by loan investors as Libor rates rise will stop when Libor is higher than Libor floor rates, as coupon payments increase and loan returns improve.
Higher Libor rates than Libor floors will improve the economics of newer deals, compared to older deals and may give higher secondary prices.
"After Libor breaches Libor floors, the overall increase in the level of interest rates will mean that most CLO equity holders will be content with their returns," the second CLO manager said.
With three-month Libor rates still well below average Libor floor levels, most CLO buyers are happy for Libor floors to remain as a component of loan structures, banking sources say.
Despite the aforementioned concerns, due to their floating rate nature, bank loans have outperformed other asset classes during periods of rising rates.
"While CLOs will definitely see equity distributions decline when the Libor floor excess goes away, absolute return (non-structured) loan investors benefit in a rising rate environment. That has been borne out in virtually every rate hiking period in history, where loans have outperformed other fixed income asset classes every time,” said Beth MacLean, executive vice president and bank loan portfolio manager at PIMCO.
Editing By Jon Methven and Tessa Walsh