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ETF News

LPC: US firms cut Libor floors on leveraged loans as rates rise

Aug 5 (Reuters) - Companies including chipmaker Avago Technologies and food product producer Pinnacle Foods are issuing leveraged loans without Libor floors as the key benchmark rate rises.

Libor floors, which guarantee minimum returns for leveraged loans, were used to boost yields and make loans more attractive for investors as Libor slumped more than 80 percent during the financial crisis to less than 1 percent in May 2009, dragging yields lower.

With Libor now at a seven-year high of 79 basis points on August 4, up from 61 basis points on December 31, the floors are eating into payments made to equity holders of Collateralized Loan Obligation (CLO) funds, the biggest buyers of leveraged loans.

More companies are starting to issue loans without Libor floors. In July, 10 percent of companies that issued loans opted to do so with no floor or set a minimum rate of zero percent, up from 3 percent of loans in the third quarter of 2015, according to Thomson Reuters LPC data.

“As Libor rises, there is less and less value to the floor,” Gil Tollinchi, a managing director at Crescent Capital Group in New York, said.

Libor floors were introduced to increase yield by guaranteeing Libor at a certain level -- typically 100 basis points or 75 basis points, according to Jed Zobitz, a partner in the corporate department at law firm Cravath, Swaine & Moore.

Higher Libor rates are directly related to October’s looming money market reform deadline, as significant amounts of assets under management are transferred from prime funds to government funds before that deadline, Matt Hornbach, global head of rates strategy at Morgan Stanley, said.

Prime funds are large buyers of financial commercial paper (CP) and certificate of deposits, and Libor has been set higher as financial CP rates have been driven higher, Hornbach said.

JP Morgan expects three-month Libor to be 70 basis points in three months, 95 basis points in six months and 115 basis points in a year. DIRECT BENEFIT

Libor floors have directly benefited holders of CLO equity, the most junior slice of the funds. When Libor was 25 basis points and most loans had floors of 100 basis points, the extra 75 basis points increased annual cash payments to equity investors by around 7.5 percent for CLOs with 10 times leverage, said Mia Qian, a CLO analyst at Morgan Stanley.

CLO equity returns fall when Libor rises but remains below the level of the floor. Loan interest payments to CLOs remain constant because of the floors in place. CLOs do not have floors, however, and the rate funds pay to their debt investors rises as Libor increases, which eats up the excess spread that equity holders would otherwise have received.

Falling CLO equity returns and an anticipated 60 percent drop in CLO issuance this year due to upcoming risk-retention rules that require managers to hold a portion of their fund’s risk are leading many firms to ask for Libor floors to be eliminated altogether.

In January investors asked Citigroup, one of the banks arranging a $2.525 billion loan backing the purchase of Petco Animal Supplies by CVC Capital Partners and the Canada Pension Plan Investment Board, to remove a Libor floor.

Despite this precedent, most loans were still issued with Libor floors until June. At least five companies, including Pinnacle and Avago, issued loans without Libor floors or a minimum of zero percent since then, according to LPC data.

Last month New Jersey-based Pinnacle Foods repriced its existing term loan and removed a 0.75 percent floor and California-based Avago sought a $6.6 billion loan that did not include a 0.75 percent floor that was in its previous financing.

Avago and Petco spokespeople declined to comment. A Pinnacle Foods spokesperson did not return a telephone call seeking comment.

With further rises in Libor anticipated, more borrowers are expected to follow suit and issue loans without Libor floors.

“You’ll continue to see a trend where higher-rated issuers are doing more deals without floors,” William Hughes, head of leveraged syndicate at Citigroup, said. (Reporting by Kristen Haunss; Additional reporting by Jonathan Schwarzberg; Editing by Michelle Sierra and Tessa Walsh)

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