Loan-Rate Reductions May Lower CLO Payout, Morgan Stanley Says

The wave of recent leveraged-loan interest-rate reductions may cut distributions to investors in the riskiest portions of collateralized loan obligations, according to Morgan Stanley.

The decline in cash payouts to the so-called equity holders of funds could, on average, be about a point lower, and may be 6.5 to 7 points less if loan-rate decreases continue at the same rate for the rest of the year, according to a report from the bank today.

Companies are taking advantage of an influx of cash from CLOs and loan mutual funds to cut interest payments and loosen terms. Of the 151 institutional loans issued this year as of Feb. 21, 101 were for refinancing purposes, Morgan Stanley analysts led by Vishwanath Tirupattur wrote in the report. While loan spreads declined, CLO spreads remained relatively flat, making the arbitrage difficult, according to Morgan Stanley.

“Lower asset spreads do put pressure on CLO economics as equity arbitrage becomes more challenging,” the analysts wrote. “If CLO liability spreads also tighten correspondingly, new CLO formation can continue its robust pace.”

There were $15 billion of CLOs raised this year as of Feb. 22, according to JPMorgan Chase & Co. data. The amount of CLOs backed by widely syndicated loans arranged in the U.S. last year totaled $52.6 billion, according to data compiled by Bloomberg.

Libor Floor

As part of the loan repricings, companies have also cut the minimum level at which the London interbank offered rate can be set, which can also affect equity payouts, the analysts wrote. The average Libor floor level for refinanced loans declined 23 basis points compared to the original terms. Libor is a rate banks say they can borrow in dollars from each other. A basis point is 0.01 percentage point.

Seventy-three percent of loans issued this year were used to refinance existing debt, according to the report, citing Standard & Poor’s Capital IQ Leveraged Commentary & Data. Financing spreads on these deals are now lower on average by 110 basis points, the analysts wrote.

CLOs are a type of collateralized debt obligation that pool high-yield, high-risk loans and slice them into securities of varying risk and return.

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