Leveraged Loan Market Asked to Stop Pretending Rates Aren’t LowKristen Haunss and Michelle F. Davis
When the U.S. Federal Reserve cut borrowing costs to almost zero back in 2008, the leveraged-loan market came up with a solution to ensure that yields on the debt didn’t follow: it set its own benchmark.
So were born “Libor floors,” which established a minimum interest level the floating-rate debt pays lenders regardless of how low the benchmark falls. Today, floors average 1 percent even though three-month Libor is less than 0.3 percent. In all, rates on about 90 percent of leveraged loans remain fixed as long as the London interbank offered rate stays below that floor.
Now, some firms such as Angelo Gordon & Co. and Marathon Asset Management, which pool the debt into collateralized loan obligations, are pushing for an end to the practice amid concern that some of their investors may receive lower payments as the Fed moves to raise rates. Opposing the elimination are investors including Pacific Investment Management Co. who argue yields would fall without the floors.
“Some people are of the view that we needed floors because it was protecting us against a decline in Libor and that now we don’t need that,” said Jonathan Insull, a New York-based money manager at Crescent Capital Group, which oversees about $17 billion of speculative-grade debt. “You don’t need a parachute when you’re standing on the ground.”
An effort to forgo a floor for a $2.125 billion loan last month for Santa Clara, California-based software firm Avaya Inc. fell short, according to two people with knowledge of the matter. The loan pays interest at 5.25 percentage points more than Libor, with a one percent minimum on the lending benchmark, according to data compiled by Bloomberg. Jeremiah Glodoveza, an Avaya spokesman, declined to comment.
The debate about the floors erupted in March in e-mail exchanges among some of the market’s biggest investors.
“It is time to get rid of the Libor floor for new issues,” Bruce Martin, who runs non-distressed corporate credit at Angelo Gordon, said in an e-mail that was obtained by Bloomberg. “The buy-side should move now.”
Forest Wolfe, general counsel at New York-based Angelo Gordon, declined to comment about the e-mails.
“If Libor spiked tomorrow to anything less than 100 basis points, CLO equities would be under extreme pressure and new CLO formation would probably stop in its tracks,” Martin wrote in the e-mail. Angelo Gordon manages about $27 billion, with about $3 billion in CLOs.
Future traders don’t expect Libor will reach that level till after March, six months after the Fed is projected to increase its benchmark rate.
Floors on leveraged loans became popular after the financial crisis when three-month dollar Libor plunged to an average of 0.37 percent since 2009 from as high as 5.725 percent in September 2007. The rate is currently set at 0.29 percent.
The portion of outstanding loans with a Libor floor was less than 10 percent seven years ago, according to Morgan Stanley. Now it’s 90.8 percent.
For CLOs, which pool high-yield corporate loans and slice them into securities of varying risk and return, the measure proved to be of great benefit.
Returns for the riskiest portion of CLOs, the so-called equity tranche, were boosted by about an extra 7.5 percentage points a year due to Libor floors, according to Morgan Stanley.
Those gains may now evaporate if rates rise, fear some CLO managers.
Investors who buy CLO debt receive interest payments at a coupon plus Libor. As Libor rises to a level just below the floor, typically 1 percent, the amount a CLO must pay its investors increases, while the amount of interest received from the loans it owns stays the same. This leaves less for equity investors, who are paid after debt-holders get their distributions.
Concerns that keeping the floors will hurt CLOs is underpinned by new regulations that go into effect next year, which will require managers to hold at least 5 percent of their deals. The proposed rule is cited as a reason behind pessimistic forecasts for CLO issuance.
JPMorgan Chase & Co. expects CLO sales of $70 billion to $80 billion in 2015, after record issuance of $123.6 billion last year.
Libor floors “serve limited function for investors and had never been a part of the market pre-crisis,” Andrew Brady, a managing director at Marathon, which oversees about $13 billion in assets, said in an e-mailed statement.
Managers like Martin and Brady say the floors are obsolete and want borrowers to issue loans without the minimum rate, hoping they’ll compensate lenders instead with a boosted spread over Libor.
“The idea that the loan market could trade the floors that exists today for additional spread is pure fantasy,” Beth MacLean, a money manager at Pimco, said in a telephone interview. “It’s all about supply and demand, and if we give issuers an inch, they will take a mile and then we will have lower spreads and no floors.”
New loan issuance of $100.4 billion this year is down about 40.5 percent, compared with the similar period in 2014, Bloomberg data show. This lack of new deals has allowed borrowers to pay reduced rates, with 21 companies renegotiating interest costs last month.
“This is unchartered waters and there are no guarantees that once a Libor floor is removed, the spread compensation will offset that historical bump in coupon,” said Jason Rosiak, who heads portfolio management at Newport Beach, California-based Pacific Asset Management, and “is in the Libor floor camp.”
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